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Warsaw 2011
Conceptualizing interdependences between regulatory and monetary policies.
Some preliminary considerations
Łukasz Hardt
NATIONAL BANK OF POLANDWORKING PAPER
No. 96
Design:
Oliwka s.c.
Layout and print:
NBP Printshop
Published by:
National Bank of Poland Education and Publishing Department 00-919 Warszawa, 11/21 Świętokrzyska Street phone: +48 22 653 23 35, fax +48 22 653 13 21
© Copyright by the National Bank of Poland, 2011
http://www.nbp.pl
This research project was conducted under the NBP Economic Research Committee’s open competition for research projects to be carried out by the NBP staff and economists from outside the NBP and was financed by the National Bank of Poland.
Contents
WORKING PAPER No. 96 3
Contents
Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1 . Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2 . Monetary policy and its transmission channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2 .1 . The Interest Rate Channel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2 .2 . The Exchange Rate Channel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2 .3 . Other asset price effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2 .4 . Credit channel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3 . Do institutions really matter for monetary transmission? Some empirical and theoretical insights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3 .1 . Lessons from financial globalization debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
3 .2 . Between investment and saving constrained economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
3 .3 . Conceptualizing the interplay between institutions and transaction costs . . . . . . . . . . . . . . . . . . . . . . . 16
4 . Putting institutions into transmission mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
5 . Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Abstract
N a t i o n a l B a n k o f P o l a n d4
1
Łukasz Hardt1
Abstract. In this paper we investigate the interplay between regulatory and
monetary policies. We analyze how changes in institutional settings modify
the functioning of various channels of monetary transmission. The paper
begins with a brief presentation of the main channels of monetary
transmission, including credit channel, exchange rate channel, Tobin q
theory, and the credit channel. After that we define a positive institutional
change and we check how such adjustments can be put into the logic of
monetary transmission. We show that the most profound way institutions
impact the monetary transmission is via its effect on the elasticity of
investments to changes in interest rates.
Key words: monetary transmission channels, monetary policy, regulatory
policy, institutional change, financial globalization
JEL codes: E02, E44, E52, F41, O43
1 Faculty of Economic Sciences, University of Warsaw, and Institute of Economics, Polish Academy of Sciences ([email protected]). This research was financed by a grant from the National Bank of Poland. I would like to thank participants of a research seminar held at the National Bank of Poland on 28/10/10 for stimulating comments that significantly helped in improving the paper. Also, I thank an anonymous referee for very useful comments and suggestions. The usual disclaimer applies.
Introduction
WORKING PAPER No. 96 5
1
2
There is a widespread consensus among economists that the impact of monetary policy on the
real economy depends on the kind of fiscal policy that is implemented by the government.
The interplay between fiscal policy and the monetary one is conceptualized in many
theoretical models of which the textbook ISLM is the best known. Accordingly, if one wants,
for instance, to evaluate the impact of lowering an interest rate on the investment activity in a
given economy, he must take into account the government economic policy, e.g., if corporate
taxes are cut, then lower interest rates should stimulate the investment activity more than in
the situation of unchanged taxes. However, in recent years there has been a growing amount
of literature suggesting that the real economy is not only influenced by the monetary/fiscal
policy mix, but also by the institutional factors, i.e., the law regulating the functioning of the
economy, culture (social and moral norms), the quality of governance, the level of corruption,
and others (e.g., North 1990, 2005, Acemoglu et al. 2004, Acemoglu et al. 2005, Rodrik et al.
2004). Nevertheless, what lacks in the literature is a theoretical conceptualization of the
interplay between monetary and regulatory policy as well as a precise definition of “good”
(growth stimulating) regulatory reforms. A search for such a “monetary/regulatory policy mix
model” motivates the research presented in this paper. The analysis proceeds as follows. First,
we present the basic transmission channels of monetary policy or, in other words, we ask how
monetary policy can influence the real side of the economy. Second, we define regulatory
policy as well as we conceptualize a positive regulatory reform. Third, we show how
regulatory changes can influence the strength with which the monetary policy impacts the
economy (through various channels of transmission). Conclusions follow.
One of the main research questions in monetary economics is how the changes in money
aggregates affect the prices, interest rates, and output (Walsh 2010). That is important for at
least two reasons. First, most economists would agree that at least in the short run monetary
policy can affect the real side of a given economy (Bernanke et al. 1995, 27). Second, in order
2 That part of paper is based on the description of monetary transmission mechanisms presented in Mishkin (1995) and Boivin et al. (2010).
Monetary policy and its transmission channels
N a t i o n a l B a n k o f P o l a n d6
2
2
There is a widespread consensus among economists that the impact of monetary policy on the
real economy depends on the kind of fiscal policy that is implemented by the government.
The interplay between fiscal policy and the monetary one is conceptualized in many
theoretical models of which the textbook ISLM is the best known. Accordingly, if one wants,
for instance, to evaluate the impact of lowering an interest rate on the investment activity in a
given economy, he must take into account the government economic policy, e.g., if corporate
taxes are cut, then lower interest rates should stimulate the investment activity more than in
the situation of unchanged taxes. However, in recent years there has been a growing amount
of literature suggesting that the real economy is not only influenced by the monetary/fiscal
policy mix, but also by the institutional factors, i.e., the law regulating the functioning of the
economy, culture (social and moral norms), the quality of governance, the level of corruption,
and others (e.g., North 1990, 2005, Acemoglu et al. 2004, Acemoglu et al. 2005, Rodrik et al.
2004). Nevertheless, what lacks in the literature is a theoretical conceptualization of the
interplay between monetary and regulatory policy as well as a precise definition of “good”
(growth stimulating) regulatory reforms. A search for such a “monetary/regulatory policy mix
model” motivates the research presented in this paper. The analysis proceeds as follows. First,
we present the basic transmission channels of monetary policy or, in other words, we ask how
monetary policy can influence the real side of the economy. Second, we define regulatory
policy as well as we conceptualize a positive regulatory reform. Third, we show how
regulatory changes can influence the strength with which the monetary policy impacts the
economy (through various channels of transmission). Conclusions follow.
One of the main research questions in monetary economics is how the changes in money
aggregates affect the prices, interest rates, and output (Walsh 2010). That is important for at
least two reasons. First, most economists would agree that at least in the short run monetary
policy can affect the real side of a given economy (Bernanke et al. 1995, 27). Second, in order
2 That part of paper is based on the description of monetary transmission mechanisms presented in Mishkin (1995) and Boivin et al. (2010).
2
There is a widespread consensus among economists that the impact of monetary policy on the
real economy depends on the kind of fiscal policy that is implemented by the government.
The interplay between fiscal policy and the monetary one is conceptualized in many
theoretical models of which the textbook ISLM is the best known. Accordingly, if one wants,
for instance, to evaluate the impact of lowering an interest rate on the investment activity in a
given economy, he must take into account the government economic policy, e.g., if corporate
taxes are cut, then lower interest rates should stimulate the investment activity more than in
the situation of unchanged taxes. However, in recent years there has been a growing amount
of literature suggesting that the real economy is not only influenced by the monetary/fiscal
policy mix, but also by the institutional factors, i.e., the law regulating the functioning of the
economy, culture (social and moral norms), the quality of governance, the level of corruption,
and others (e.g., North 1990, 2005, Acemoglu et al. 2004, Acemoglu et al. 2005, Rodrik et al.
2004). Nevertheless, what lacks in the literature is a theoretical conceptualization of the
interplay between monetary and regulatory policy as well as a precise definition of “good”
(growth stimulating) regulatory reforms. A search for such a “monetary/regulatory policy mix
model” motivates the research presented in this paper. The analysis proceeds as follows. First,
we present the basic transmission channels of monetary policy or, in other words, we ask how
monetary policy can influence the real side of the economy. Second, we define regulatory
policy as well as we conceptualize a positive regulatory reform. Third, we show how
regulatory changes can influence the strength with which the monetary policy impacts the
economy (through various channels of transmission). Conclusions follow.
One of the main research questions in monetary economics is how the changes in money
aggregates affect the prices, interest rates, and output (Walsh 2010). That is important for at
least two reasons. First, most economists would agree that at least in the short run monetary
policy can affect the real side of a given economy (Bernanke et al. 1995, 27). Second, in order
2 That part of paper is based on the description of monetary transmission mechanisms presented in Mishkin (1995) and Boivin et al. (2010).
3
to decide on the appropriate set of monetary policy instruments, the monetary authority needs
to know how these instruments can affect the economy. Last but not least, the post2008 crisis
proved that financial disturbances, deeply intertwined with monetary policy, influenced
profoundly the real economy, causing the socalled Great Recession. Although there is a
consensus that monetary policy matters, there is an ongoing discussion on how monetary
policy affects the real economy. That is even more visible if one takes a look at very basic
relationships between monetary variables, e.g., nominal US federal funds rate, and
macroeconomic ones, e.g., growth in aggregate activity and expenditure. It appears that the
correlations shifted from negative in the periods from 1962Q1 to 1979Q3 to positive form
1984Q1 till 2008Q4 (Boivin et al. 2010, 2). We are to touch upon that issue in our discussion
on the interplay between monetary and regulatory policy. Now, we simply present the basic
transmission channels, i.e., interest rate effects, exchange rate effects, other asset price effects,
and the socalled credit channel3.
The mechanism of interest rate transmission is the most well known and is present in
economic literature for over 60 years. It is also well known to the public under the simple
heuristic that lower interest rates positively stimulate the economy. Also, that mechanism is
included in every macroeconomics textbook presentation of basic Keynesian framework. It
proceeds as follows:
M ↓ => i ↑ => I ↓ => Y ↓,
where M ↓ indicates the contractionary monetary policy leading to a rise in real interest rates
(i ↑), which by rising the cost of capital causes a decline in investment spending (I ↓) and
hence a general fall in output (Y ↓).
The above described mechanism matters for both producers’ and consumers’
decisions. Interestingly, the interest rate mechanism does not only influence
consumers’/producers’ spending via changes in shortrun interest rate but also by changing
the longrun interest rate through a combination of sticky prices and rational expectations
(Taylor 1995).
3 Although we are conscious that nowadays monetary authorities use primarily interest rate targeting, here we assume that monetary impulse comes from a change in money supply. The discussion why currently central banks use mainly interest rate targeting is beyond the scope of this paper.
3
to decide on the appropriate set of monetary policy instruments, the monetary authority needs
to know how these instruments can affect the economy. Last but not least, the post2008 crisis
proved that financial disturbances, deeply intertwined with monetary policy, influenced
profoundly the real economy, causing the socalled Great Recession. Although there is a
consensus that monetary policy matters, there is an ongoing discussion on how monetary
policy affects the real economy. That is even more visible if one takes a look at very basic
relationships between monetary variables, e.g., nominal US federal funds rate, and
macroeconomic ones, e.g., growth in aggregate activity and expenditure. It appears that the
correlations shifted from negative in the periods from 1962Q1 to 1979Q3 to positive form
1984Q1 till 2008Q4 (Boivin et al. 2010, 2). We are to touch upon that issue in our discussion
on the interplay between monetary and regulatory policy. Now, we simply present the basic
transmission channels, i.e., interest rate effects, exchange rate effects, other asset price effects,
and the socalled credit channel3.
The mechanism of interest rate transmission is the most well known and is present in
economic literature for over 60 years. It is also well known to the public under the simple
heuristic that lower interest rates positively stimulate the economy. Also, that mechanism is
included in every macroeconomics textbook presentation of basic Keynesian framework. It
proceeds as follows:
M ↓ => i ↑ => I ↓ => Y ↓,
where M ↓ indicates the contractionary monetary policy leading to a rise in real interest rates
(i ↑), which by rising the cost of capital causes a decline in investment spending (I ↓) and
hence a general fall in output (Y ↓).
The above described mechanism matters for both producers’ and consumers’
decisions. Interestingly, the interest rate mechanism does not only influence
consumers’/producers’ spending via changes in shortrun interest rate but also by changing
the longrun interest rate through a combination of sticky prices and rational expectations
(Taylor 1995).
3 Although we are conscious that nowadays monetary authorities use primarily interest rate targeting, here we assume that monetary impulse comes from a change in money supply. The discussion why currently central banks use mainly interest rate targeting is beyond the scope of this paper.
Monetary policy and its transmission channels
WORKING PAPER No. 96 7
2
3
to decide on the appropriate set of monetary policy instruments, the monetary authority needs
to know how these instruments can affect the economy. Last but not least, the post2008 crisis
proved that financial disturbances, deeply intertwined with monetary policy, influenced
profoundly the real economy, causing the socalled Great Recession. Although there is a
consensus that monetary policy matters, there is an ongoing discussion on how monetary
policy affects the real economy. That is even more visible if one takes a look at very basic
relationships between monetary variables, e.g., nominal US federal funds rate, and
macroeconomic ones, e.g., growth in aggregate activity and expenditure. It appears that the
correlations shifted from negative in the periods from 1962Q1 to 1979Q3 to positive form
1984Q1 till 2008Q4 (Boivin et al. 2010, 2). We are to touch upon that issue in our discussion
on the interplay between monetary and regulatory policy. Now, we simply present the basic
transmission channels, i.e., interest rate effects, exchange rate effects, other asset price effects,
and the socalled credit channel3.
The mechanism of interest rate transmission is the most well known and is present in
economic literature for over 60 years. It is also well known to the public under the simple
heuristic that lower interest rates positively stimulate the economy. Also, that mechanism is
included in every macroeconomics textbook presentation of basic Keynesian framework. It
proceeds as follows:
M ↓ => i ↑ => I ↓ => Y ↓,
where M ↓ indicates the contractionary monetary policy leading to a rise in real interest rates
(i ↑), which by rising the cost of capital causes a decline in investment spending (I ↓) and
hence a general fall in output (Y ↓).
The above described mechanism matters for both producers’ and consumers’
decisions. Interestingly, the interest rate mechanism does not only influence
consumers’/producers’ spending via changes in shortrun interest rate but also by changing
the longrun interest rate through a combination of sticky prices and rational expectations
(Taylor 1995).
3 Although we are conscious that nowadays monetary authorities use primarily interest rate targeting, here we assume that monetary impulse comes from a change in money supply. The discussion why currently central banks use mainly interest rate targeting is beyond the scope of this paper.
4
Changes in M in open economies also influence Y by affecting the exchange rate. It goes as
follows: a rise in i makes domestic deposits more attractive visàvis foreign ones and hence
attracting the inflow of foreign capital leading to a raise in the value of domestic currency,
i.e., its appreciation (E ↑), and therefore a fall in net exports (NX ↓). Schematically, it can be
presented as follows:
M ↓ => i ↑ => E ↑ => NX ↓ => Y ↓.
Since most developed economies are open ones that transmission channel matters and should
be taken into account while deciding on appropriate monetary policy actions (Obstfeld et al.
1995).
As Meltzer (1995) points out, a basic shortcoming of the above described channels is their
focus only on one relative asset price, the interest rate. According to his contribution adding
another relative price, namely exchange rate changes nothing. Instead, monetarists postulate
to take into account the universe of relative asset prices and real wealth. However, among
many, two channels are worth emphasizing here: Tobin’s q theory and wealth effects on
consumption.
Tobin’s q theory conceptualizes the monetary transmission through its effects on the
valuation of equities. In his approach, we have RCCMVFq , where MVF stands for market
value of firms and RCC for replacement cost of capital. If q is high, MFV is high relative to
RCC, and new plant and equipment capital is cheap relative to the market value of firms. Thus
companies can easily issue equity and get a high price for it relative to the cost of the plant
and equipment they are to buy. Therefore, investment spending will rise, because firms can
buy a lot using only a small amounts of stocks. If q is low, companies can hardly buy any new
capital and instead they would buy existing firms and thus acquiring old (existing) capital.
Investments will be low.
How the monetary authority can influence q or alternatively how it can affect equity
prices? As often the story begins with the changes in money supply. If monetary authority
decreases M, then there is a lack of money in the economy, so the public diminishes their
Monetary policy and its transmission channels
N a t i o n a l B a n k o f P o l a n d8
2
5
expenses. People can spend less for instance in the stock market what results in the lower
equity prices. This story can be seen also from a more Keynesian like side where lower I (the
result of M ↓) makes bonds more attractive than equity, so we have Pe ↓, where Pe stands for
equity prices. Consequently, the above described mechanism can be written down as follows:
M ↓ => Pe ↓ => q ↓ => I ↓ => Y↓.
Changes in equity prices not only influence q but also consumers’ wealth and hence their
consumption as F. Modigliani in his MITPennSSRC (MPS) model claims. If equity prices
fall, then the value of financial wealth decreases, thus decreasing the lifetime resources for
consumption and hence inducing a fall in consumption spending (Modigliani 1971). So, if
M ↓, then Pe↓ and hence consumption falls as well, i.e.:
M ↓ => Pe ↓ => wealth ↓ => consumption ↓ => Y↓.
The Modigliani approach offers an explanation for many empirical phenomena the previously
described transmission channels could not explain, e.g., the impact of monetary policy on
Japanese economy in the 1980s and 1990s through its effect on land and property values.
However, what integrates all these channels is the assumption of perfect financial markets
(Boivin et al. 2010, 5). If we ease that neoclassical assumption, then a new perspective arises.
In case of asymmetric information and problems in enforcing contracts in financial markets,
the agency problems are created. Also, the government intervention can strongly disrupt the
functioning of financial markets. In general, the transmission channels arising from market
imperfections are present in credit markets and hence they are called credit channels or more
generally nonneoclassical transmission channels. There are three basic channels of that kind,
i.e., changes in credit supply resulting from government interventions, the bank lending
channel, and balancesheet channel.
Effects on credit supply from government interventions. Governments often try to
influence the functioning of credit markets in order to achieve some policy objective, e.g.,
encouraging particular types of investments. The typical case of that kind of intervention is
the policy of US government which aims at making ownership of private houses more
common, for instance, they helped saving and loan association. These kind of policy
4
Changes in M in open economies also influence Y by affecting the exchange rate. It goes as
follows: a rise in i makes domestic deposits more attractive visàvis foreign ones and hence
attracting the inflow of foreign capital leading to a raise in the value of domestic currency,
i.e., its appreciation (E ↑), and therefore a fall in net exports (NX ↓). Schematically, it can be
presented as follows:
M ↓ => i ↑ => E ↑ => NX ↓ => Y ↓.
Since most developed economies are open ones that transmission channel matters and should
be taken into account while deciding on appropriate monetary policy actions (Obstfeld et al.
1995).
As Meltzer (1995) points out, a basic shortcoming of the above described channels is their
focus only on one relative asset price, the interest rate. According to his contribution adding
another relative price, namely exchange rate changes nothing. Instead, monetarists postulate
to take into account the universe of relative asset prices and real wealth. However, among
many, two channels are worth emphasizing here: Tobin’s q theory and wealth effects on
consumption.
Tobin’s q theory conceptualizes the monetary transmission through its effects on the
valuation of equities. In his approach, we have RCCMVFq , where MVF stands for market
value of firms and RCC for replacement cost of capital. If q is high, MFV is high relative to
RCC, and new plant and equipment capital is cheap relative to the market value of firms. Thus
companies can easily issue equity and get a high price for it relative to the cost of the plant
and equipment they are to buy. Therefore, investment spending will rise, because firms can
buy a lot using only a small amounts of stocks. If q is low, companies can hardly buy any new
capital and instead they would buy existing firms and thus acquiring old (existing) capital.
Investments will be low.
How the monetary authority can influence q or alternatively how it can affect equity
prices? As often the story begins with the changes in money supply. If monetary authority
decreases M, then there is a lack of money in the economy, so the public diminishes their
Monetary policy and its transmission channels
WORKING PAPER No. 96 9
2 5
expenses. People can spend less for instance in the stock market what results in the lower
equity prices. This story can be seen also from a more Keynesian like side where lower I (the
result of M ↓) makes bonds more attractive than equity, so we have Pe ↓, where Pe stands for
equity prices. Consequently, the above described mechanism can be written down as follows:
M ↓ => Pe ↓ => q ↓ => I ↓ => Y↓.
Changes in equity prices not only influence q but also consumers’ wealth and hence their
consumption as F. Modigliani in his MITPennSSRC (MPS) model claims. If equity prices
fall, then the value of financial wealth decreases, thus decreasing the lifetime resources for
consumption and hence inducing a fall in consumption spending (Modigliani 1971). So, if
M ↓, then Pe↓ and hence consumption falls as well, i.e.:
M ↓ => Pe ↓ => wealth ↓ => consumption ↓ => Y↓.
The Modigliani approach offers an explanation for many empirical phenomena the previously
described transmission channels could not explain, e.g., the impact of monetary policy on
Japanese economy in the 1980s and 1990s through its effect on land and property values.
However, what integrates all these channels is the assumption of perfect financial markets
(Boivin et al. 2010, 5). If we ease that neoclassical assumption, then a new perspective arises.
In case of asymmetric information and problems in enforcing contracts in financial markets,
the agency problems are created. Also, the government intervention can strongly disrupt the
functioning of financial markets. In general, the transmission channels arising from market
imperfections are present in credit markets and hence they are called credit channels or more
generally nonneoclassical transmission channels. There are three basic channels of that kind,
i.e., changes in credit supply resulting from government interventions, the bank lending
channel, and balancesheet channel.
Effects on credit supply from government interventions. Governments often try to
influence the functioning of credit markets in order to achieve some policy objective, e.g.,
encouraging particular types of investments. The typical case of that kind of intervention is
the policy of US government which aims at making ownership of private houses more
common, for instance, they helped saving and loan association. These kind of policy
6
mechanisms are present everywhere in developed countries, including Poland where the
regulations issued by the Polish Financial Supervision Authority proved to have an important
impact on the functioning of housing credit market.
Bank lending channel. Banks play a significant role in financing investment activity of
firms. That is more important in case of small and medium seized enterprises that do not have
an easy access to stock markets. Also, banks are well suited to deal with problems arising
from asymmetric information that are more persistent in the case of SMEs. The lending ability
of banks can have an enormous effect on functioning of that group of firms. Therefore, an
expansionary monetary policy which increases banks’ reserves and deposits will have an
impact on banks’ behavior. In standard notation the process goes as follows:
M ↑ => bank deposits ↑ => bank loans ↑ => I ↑ => Y ↑.
As was mentioned earlier, the above described process will have a greater effect on SMEs.
Balancesheet channel. Another interesting way the monetary policy can influence the
real side of the economy is through the socalled balancesheet channel. Here, the
transmission mechanism operates through the net worth of business firms (and other potential
borrowers). When potential borrowers’ net worth falls, then adverse selection and moral
hazard problems increase in credit markets. If there is a decrease in equity stakes of firms,
then they are more willing to engage in risky investment projects. If so, then also banks
become more cautious in giving credits and hence a decrease in lending leads to a decrease in
investment activities.
Monetary policy by affecting the prices of equities lowers the net worth of firms what
leads to lower investments and a decrease in aggregate demand, because of the increase in
adverse selection and moral hazard problems. Schematically that mechanism is presented
below:
M ↓ => Pe ↓ => adverse selection ↑ & moral hazard ↑ => lending ↓ => I ↓ => Y↓.
Therefore, asset prices seems to have an important role in transmitting monetary signals to the
economy.
Another way the contractionary monetary policy affects firms’ balance sheets is
through its effect on cash flow. If firms are to pay higher interest payments, the result of a rise
in i, then they cash flow diminishes. Since external funding is subject to adverse selection and
Monetary policy and its transmission channels
N a t i o n a l B a n k o f P o l a n d10
2 6
mechanisms are present everywhere in developed countries, including Poland where the
regulations issued by the Polish Financial Supervision Authority proved to have an important
impact on the functioning of housing credit market.
Bank lending channel. Banks play a significant role in financing investment activity of
firms. That is more important in case of small and medium seized enterprises that do not have
an easy access to stock markets. Also, banks are well suited to deal with problems arising
from asymmetric information that are more persistent in the case of SMEs. The lending ability
of banks can have an enormous effect on functioning of that group of firms. Therefore, an
expansionary monetary policy which increases banks’ reserves and deposits will have an
impact on banks’ behavior. In standard notation the process goes as follows:
M ↑ => bank deposits ↑ => bank loans ↑ => I ↑ => Y ↑.
As was mentioned earlier, the above described process will have a greater effect on SMEs.
Balancesheet channel. Another interesting way the monetary policy can influence the
real side of the economy is through the socalled balancesheet channel. Here, the
transmission mechanism operates through the net worth of business firms (and other potential
borrowers). When potential borrowers’ net worth falls, then adverse selection and moral
hazard problems increase in credit markets. If there is a decrease in equity stakes of firms,
then they are more willing to engage in risky investment projects. If so, then also banks
become more cautious in giving credits and hence a decrease in lending leads to a decrease in
investment activities.
Monetary policy by affecting the prices of equities lowers the net worth of firms what
leads to lower investments and a decrease in aggregate demand, because of the increase in
adverse selection and moral hazard problems. Schematically that mechanism is presented
below:
M ↓ => Pe ↓ => adverse selection ↑ & moral hazard ↑ => lending ↓ => I ↓ => Y↓.
Therefore, asset prices seems to have an important role in transmitting monetary signals to the
economy.
Another way the contractionary monetary policy affects firms’ balance sheets is
through its effect on cash flow. If firms are to pay higher interest payments, the result of a rise
in i, then they cash flow diminishes. Since external funding is subject to adverse selection and
7
moral hazard problems, additional reliance on external sources of capital leads to cuttings in
investments. Here what matters is the nominal interest rate rather than the real one as in the
case of neoclassical channels. Moreover, short terms interest rates are even more important
here since they usually have a profound effect on firms’ cash flow. It works as follows:
M ↓ => i ↑ => cash flow ↓ => adverse selection ↑ & moral hazard ↑ => lending ↓ => I ↓ => Y↓.
As Bernanke and Gertler (1995) suggest the credit channel does not affect only firms but also
households. Declining bank lending causes a decline in durables and housing purchases by
consumers whose only source of capital is from the banks’ credit action. Also, an increase in i
deteriorates the balance sheet of a consumer in the same vein as in the case of firms.
As Mishkin (1978) proposes in his liquidityeffects view, balance sheet affects
consumers’ desire to spend. If consumers are afraid of finding themselves in financial distress,
then they would hold more liquid assets and hence reducing their spending on illiquid ones
such as houses. If stock prices fall, then consumers’ expenditures on durables will also fall,
because consumers’ financial position deteriorates since there is a growing risk of financial
distress on their side. Therefore:
M ↓ => Pe ↓ => financial assets ↓ => likelihood of financial distress ↑ => consumer durable
and housing expenditures ↓ => Y↓.
The importance of housing prices for the functioning of credit markets depends on how
difficult it is to withdraw housing equity and that is the function of a quality of mortgage
markets. We will come back to that issue in our discussion on the interplay between
institutions and the monetary policy.
What follows from the above presentation of transmission channels, is that a raise in M
generally positively affects aggregate demand and hence the growth of GDP. Since the aim of
this paper is not to analyze the very mechanism(s) of transmission alone, we would like to
concentrate now on investigating more deeply the interplay between access to capital (here: a
rise in money supply) and output, but in the international context. So, instead of asking
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
WORKING PAPER No. 96 11
3 7
moral hazard problems, additional reliance on external sources of capital leads to cuttings in
investments. Here what matters is the nominal interest rate rather than the real one as in the
case of neoclassical channels. Moreover, short terms interest rates are even more important
here since they usually have a profound effect on firms’ cash flow. It works as follows:
M ↓ => i ↑ => cash flow ↓ => adverse selection ↑ & moral hazard ↑ => lending ↓ => I ↓ => Y↓.
As Bernanke and Gertler (1995) suggest the credit channel does not affect only firms but also
households. Declining bank lending causes a decline in durables and housing purchases by
consumers whose only source of capital is from the banks’ credit action. Also, an increase in i
deteriorates the balance sheet of a consumer in the same vein as in the case of firms.
As Mishkin (1978) proposes in his liquidityeffects view, balance sheet affects
consumers’ desire to spend. If consumers are afraid of finding themselves in financial distress,
then they would hold more liquid assets and hence reducing their spending on illiquid ones
such as houses. If stock prices fall, then consumers’ expenditures on durables will also fall,
because consumers’ financial position deteriorates since there is a growing risk of financial
distress on their side. Therefore:
M ↓ => Pe ↓ => financial assets ↓ => likelihood of financial distress ↑ => consumer durable
and housing expenditures ↓ => Y↓.
The importance of housing prices for the functioning of credit markets depends on how
difficult it is to withdraw housing equity and that is the function of a quality of mortgage
markets. We will come back to that issue in our discussion on the interplay between
institutions and the monetary policy.
What follows from the above presentation of transmission channels, is that a raise in M
generally positively affects aggregate demand and hence the growth of GDP. Since the aim of
this paper is not to analyze the very mechanism(s) of transmission alone, we would like to
concentrate now on investigating more deeply the interplay between access to capital (here: a
rise in money supply) and output, but in the international context. So, instead of asking
8
whether there is a correlation between changes in M and output in a given country, we ask
whether financial globalization contributes to the GDP growth. We switch to international
perspective since we want to check how the same monetary mechanisms work in different
institutional settings. Therefore, we present below the debate on financial globalization, then
we analyze how institutions define the way financial globalization works, and finally we offer
a conceptualization of growth stimulating institutions.
Since the source of excess money supply may be the import of the capital we should present
here the results of policies aiming at opening local financial markets. The underlying
assumption in that literature is that opening borders to the capital flows usually results in
boosting investments in countries lacking of capital (e.g., Fischer 1997). Consequently, many
opts for a greater capital mobility, e.g., as Dornbusch puts it: “The correct answer to the
question of capital mobility is that it ought to be unrestricted” (1998, 20). The argument for
financial globalization is the following: since many countries, especially developing ones, do
not have enough capital to grow, they have to open their borders for capital flows, however,
since lenders are usually quite riskaverse the capital importing countries must undertake
appropriate macroeconomic policies/reforms. In his wellknown book The Next Globalization
F. Mishkin claims that
“the emerging countries to reach the next stage of development and get rich, financial
globalization must go much further that it already has. In particular, the financial systems in
emerging economies must be more tightly integrated with those in the developed countries in
order to partake in the benefits of financial investment, the lifeblood of the industrialized
world” (Mishkin 2006, ix).
However, empirical studies show that there is an absence of any direct relation between
financial globalization and growth. It means that access to capital (money supply) alone does
not guarantee the rise in the investment activity4. The simple correlation between financial
globalization and growth is presented in Figure 1.
4 It should be mentioned here that financial globalization while not stimulating investments may foster economic growth by raising domestic consumption. However, what follows from various Rodrik’s contributions (e.g., 2008b) is that in the long run what matters for economic growth are investments, especially in technical infrastructure as well as in human capital (also Romer 1986, Lucas 1988). Consumption alone can have an important effect only in the short run. Therefore, in this paper we use ‘investments’ and ‘economic growth’ interchangeably, since we focus on the impact of financial globalization on investments as such, and we assume that investments generally stimulates growth.
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
N a t i o n a l B a n k o f P o l a n d12
3
9
Figure 1. Financial globalization and growth (19702004)
Source: Rodrik and Subramanian (2009, 119120)
There is a good set of literature investigating the lack of a significant relation between
financial globalization and growth. First, Henry (2007) argues that in modeling the effects of
8
whether there is a correlation between changes in M and output in a given country, we ask
whether financial globalization contributes to the GDP growth. We switch to international
perspective since we want to check how the same monetary mechanisms work in different
institutional settings. Therefore, we present below the debate on financial globalization, then
we analyze how institutions define the way financial globalization works, and finally we offer
a conceptualization of growth stimulating institutions.
Since the source of excess money supply may be the import of the capital we should present
here the results of policies aiming at opening local financial markets. The underlying
assumption in that literature is that opening borders to the capital flows usually results in
boosting investments in countries lacking of capital (e.g., Fischer 1997). Consequently, many
opts for a greater capital mobility, e.g., as Dornbusch puts it: “The correct answer to the
question of capital mobility is that it ought to be unrestricted” (1998, 20). The argument for
financial globalization is the following: since many countries, especially developing ones, do
not have enough capital to grow, they have to open their borders for capital flows, however,
since lenders are usually quite riskaverse the capital importing countries must undertake
appropriate macroeconomic policies/reforms. In his wellknown book The Next Globalization
F. Mishkin claims that
“the emerging countries to reach the next stage of development and get rich, financial
globalization must go much further that it already has. In particular, the financial systems in
emerging economies must be more tightly integrated with those in the developed countries in
order to partake in the benefits of financial investment, the lifeblood of the industrialized
world” (Mishkin 2006, ix).
However, empirical studies show that there is an absence of any direct relation between
financial globalization and growth. It means that access to capital (money supply) alone does
not guarantee the rise in the investment activity4. The simple correlation between financial
globalization and growth is presented in Figure 1.
4 It should be mentioned here that financial globalization while not stimulating investments may foster economic growth by raising domestic consumption. However, what follows from various Rodrik’s contributions (e.g., 2008b) is that in the long run what matters for economic growth are investments, especially in technical infrastructure as well as in human capital (also Romer 1986, Lucas 1988). Consumption alone can have an important effect only in the short run. Therefore, in this paper we use ‘investments’ and ‘economic growth’ interchangeably, since we focus on the impact of financial globalization on investments as such, and we assume that investments generally stimulates growth.
8
whether there is a correlation between changes in M and output in a given country, we ask
whether financial globalization contributes to the GDP growth. We switch to international
perspective since we want to check how the same monetary mechanisms work in different
institutional settings. Therefore, we present below the debate on financial globalization, then
we analyze how institutions define the way financial globalization works, and finally we offer
a conceptualization of growth stimulating institutions.
Since the source of excess money supply may be the import of the capital we should present
here the results of policies aiming at opening local financial markets. The underlying
assumption in that literature is that opening borders to the capital flows usually results in
boosting investments in countries lacking of capital (e.g., Fischer 1997). Consequently, many
opts for a greater capital mobility, e.g., as Dornbusch puts it: “The correct answer to the
question of capital mobility is that it ought to be unrestricted” (1998, 20). The argument for
financial globalization is the following: since many countries, especially developing ones, do
not have enough capital to grow, they have to open their borders for capital flows, however,
since lenders are usually quite riskaverse the capital importing countries must undertake
appropriate macroeconomic policies/reforms. In his wellknown book The Next Globalization
F. Mishkin claims that
“the emerging countries to reach the next stage of development and get rich, financial
globalization must go much further that it already has. In particular, the financial systems in
emerging economies must be more tightly integrated with those in the developed countries in
order to partake in the benefits of financial investment, the lifeblood of the industrialized
world” (Mishkin 2006, ix).
However, empirical studies show that there is an absence of any direct relation between
financial globalization and growth. It means that access to capital (money supply) alone does
not guarantee the rise in the investment activity4. The simple correlation between financial
globalization and growth is presented in Figure 1.
4 It should be mentioned here that financial globalization while not stimulating investments may foster economic growth by raising domestic consumption. However, what follows from various Rodrik’s contributions (e.g., 2008b) is that in the long run what matters for economic growth are investments, especially in technical infrastructure as well as in human capital (also Romer 1986, Lucas 1988). Consumption alone can have an important effect only in the short run. Therefore, in this paper we use ‘investments’ and ‘economic growth’ interchangeably, since we focus on the impact of financial globalization on investments as such, and we assume that investments generally stimulates growth.
10
financial globalization researchers focus on permanent growth effects rather than on temporal
ones and also that they do not make any difference between developed and developing
countries. Second, as Kose et al. (2006) argues, there is not a direct link between access to
capital and growth but an indirect one, namely that financial globalization requires developing
countries to undertake institutional and macroeconomic reforms. However, as Rodrik and
Subramanian (2009) rightly points out, financial globalization may ease the ineffective
governments to postpone necessary reforms by enabling them to function on a soft budget
constraint5. Third, despite the fact that Mishkin stresses the need of complementary reforms,
including getting institutions right, he simply believes that the financial globalization alone
would stimulate these reforms. That is a quite naïve assumption and also a contradictory one:
“But there is, of course, a tension, even contradiction, in implicitly calling for greater FG to
deliver the broader collateral benefits that are in turn prerequisites for FG reform to be
successful in the first place” (Rodrik and Subramanian 2009, 125). So, what are the reasons
for such disappointing effects of financial globalization? We subscribe here to the answer
given by Rodrik and Subramanian (2009) that the lack of investment in the economy can be
caused not only by the lack of access to capital but also by low perceived returns. So, we may
have plenty of financial institutions wanting to give money to prospective entrepreneurs, but,
at the same time, firms do not want to undertake any investments. Why? Simply because they
do not see any investment opportunities. These kind of economies are not saving constrained
but investment constrained. It means that the access to capital is easy and its price (interest
rate) is low. The economy is investment constrained when returns are not protected by the
legal system or the institutional structure of the economy is so corrupted that making any
transaction is simply impossible (or costly). Investment constrained economies are the ones
with high transaction costs (TCs). We will present our understanding of investment
constrained economy later in our discussion of regulatory reforms.
What happens if we open investment constrained economy and on the other hand we
do the same with saving constrained one. In the case of the latter this is a textbook story: a
reduction in the interest rate and increase in the availability of capital increase firms’
investments. Consumers are buying more due to a change in intertemporal relative prices.
Thus investments are growing and savings are declining; the difference is financed by the
external capital (Figure 2a). The situation is much more interesting in the case of investment
5 Another unintended consequence of financial globalization could be an exodus of domestic capital, since the owners of capital resources would simply search for better institutional settings as well as higher returns abroad.
10
financial globalization researchers focus on permanent growth effects rather than on temporal
ones and also that they do not make any difference between developed and developing
countries. Second, as Kose et al. (2006) argues, there is not a direct link between access to
capital and growth but an indirect one, namely that financial globalization requires developing
countries to undertake institutional and macroeconomic reforms. However, as Rodrik and
Subramanian (2009) rightly points out, financial globalization may ease the ineffective
governments to postpone necessary reforms by enabling them to function on a soft budget
constraint5. Third, despite the fact that Mishkin stresses the need of complementary reforms,
including getting institutions right, he simply believes that the financial globalization alone
would stimulate these reforms. That is a quite naïve assumption and also a contradictory one:
“But there is, of course, a tension, even contradiction, in implicitly calling for greater FG to
deliver the broader collateral benefits that are in turn prerequisites for FG reform to be
successful in the first place” (Rodrik and Subramanian 2009, 125). So, what are the reasons
for such disappointing effects of financial globalization? We subscribe here to the answer
given by Rodrik and Subramanian (2009) that the lack of investment in the economy can be
caused not only by the lack of access to capital but also by low perceived returns. So, we may
have plenty of financial institutions wanting to give money to prospective entrepreneurs, but,
at the same time, firms do not want to undertake any investments. Why? Simply because they
do not see any investment opportunities. These kind of economies are not saving constrained
but investment constrained. It means that the access to capital is easy and its price (interest
rate) is low. The economy is investment constrained when returns are not protected by the
legal system or the institutional structure of the economy is so corrupted that making any
transaction is simply impossible (or costly). Investment constrained economies are the ones
with high transaction costs (TCs). We will present our understanding of investment
constrained economy later in our discussion of regulatory reforms.
What happens if we open investment constrained economy and on the other hand we
do the same with saving constrained one. In the case of the latter this is a textbook story: a
reduction in the interest rate and increase in the availability of capital increase firms’
investments. Consumers are buying more due to a change in intertemporal relative prices.
Thus investments are growing and savings are declining; the difference is financed by the
external capital (Figure 2a). The situation is much more interesting in the case of investment
5 Another unintended consequence of financial globalization could be an exodus of domestic capital, since the owners of capital resources would simply search for better institutional settings as well as higher returns abroad.
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
WORKING PAPER No. 96 13
3
9
Figure 1. Financial globalization and growth (19702004)
Source: Rodrik and Subramanian (2009, 119120)
There is a good set of literature investigating the lack of a significant relation between
financial globalization and growth. First, Henry (2007) argues that in modeling the effects of
10
financial globalization researchers focus on permanent growth effects rather than on temporal
ones and also that they do not make any difference between developed and developing
countries. Second, as Kose et al. (2006) argues, there is not a direct link between access to
capital and growth but an indirect one, namely that financial globalization requires developing
countries to undertake institutional and macroeconomic reforms. However, as Rodrik and
Subramanian (2009) rightly points out, financial globalization may ease the ineffective
governments to postpone necessary reforms by enabling them to function on a soft budget
constraint5. Third, despite the fact that Mishkin stresses the need of complementary reforms,
including getting institutions right, he simply believes that the financial globalization alone
would stimulate these reforms. That is a quite naïve assumption and also a contradictory one:
“But there is, of course, a tension, even contradiction, in implicitly calling for greater FG to
deliver the broader collateral benefits that are in turn prerequisites for FG reform to be
successful in the first place” (Rodrik and Subramanian 2009, 125). So, what are the reasons
for such disappointing effects of financial globalization? We subscribe here to the answer
given by Rodrik and Subramanian (2009) that the lack of investment in the economy can be
caused not only by the lack of access to capital but also by low perceived returns. So, we may
have plenty of financial institutions wanting to give money to prospective entrepreneurs, but,
at the same time, firms do not want to undertake any investments. Why? Simply because they
do not see any investment opportunities. These kind of economies are not saving constrained
but investment constrained. It means that the access to capital is easy and its price (interest
rate) is low. The economy is investment constrained when returns are not protected by the
legal system or the institutional structure of the economy is so corrupted that making any
transaction is simply impossible (or costly). Investment constrained economies are the ones
with high transaction costs (TCs). We will present our understanding of investment
constrained economy later in our discussion of regulatory reforms.
What happens if we open investment constrained economy and on the other hand we
do the same with saving constrained one. In the case of the latter this is a textbook story: a
reduction in the interest rate and increase in the availability of capital increase firms’
investments. Consumers are buying more due to a change in intertemporal relative prices.
Thus investments are growing and savings are declining; the difference is financed by the
external capital (Figure 2a). The situation is much more interesting in the case of investment
5 Another unintended consequence of financial globalization could be an exodus of domestic capital, since the owners of capital resources would simply search for better institutional settings as well as higher returns abroad.
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
N a t i o n a l B a n k o f P o l a n d14
3
10
financial globalization researchers focus on permanent growth effects rather than on temporal
ones and also that they do not make any difference between developed and developing
countries. Second, as Kose et al. (2006) argues, there is not a direct link between access to
capital and growth but an indirect one, namely that financial globalization requires developing
countries to undertake institutional and macroeconomic reforms. However, as Rodrik and
Subramanian (2009) rightly points out, financial globalization may ease the ineffective
governments to postpone necessary reforms by enabling them to function on a soft budget
constraint5. Third, despite the fact that Mishkin stresses the need of complementary reforms,
including getting institutions right, he simply believes that the financial globalization alone
would stimulate these reforms. That is a quite naïve assumption and also a contradictory one:
“But there is, of course, a tension, even contradiction, in implicitly calling for greater FG to
deliver the broader collateral benefits that are in turn prerequisites for FG reform to be
successful in the first place” (Rodrik and Subramanian 2009, 125). So, what are the reasons
for such disappointing effects of financial globalization? We subscribe here to the answer
given by Rodrik and Subramanian (2009) that the lack of investment in the economy can be
caused not only by the lack of access to capital but also by low perceived returns. So, we may
have plenty of financial institutions wanting to give money to prospective entrepreneurs, but,
at the same time, firms do not want to undertake any investments. Why? Simply because they
do not see any investment opportunities. These kind of economies are not saving constrained
but investment constrained. It means that the access to capital is easy and its price (interest
rate) is low. The economy is investment constrained when returns are not protected by the
legal system or the institutional structure of the economy is so corrupted that making any
transaction is simply impossible (or costly). Investment constrained economies are the ones
with high transaction costs (TCs). We will present our understanding of investment
constrained economy later in our discussion of regulatory reforms.
What happens if we open investment constrained economy and on the other hand we
do the same with saving constrained one. In the case of the latter this is a textbook story: a
reduction in the interest rate and increase in the availability of capital increase firms’
investments. Consumers are buying more due to a change in intertemporal relative prices.
Thus investments are growing and savings are declining; the difference is financed by the
external capital (Figure 2a). The situation is much more interesting in the case of investment
5 Another unintended consequence of financial globalization could be an exodus of domestic capital, since the owners of capital resources would simply search for better institutional settings as well as higher returns abroad.
11
constrained economy where the demand schedule is vertical, so a change in the interest rate
does not affect the level of investments (Figure 2b)
Figure 2. Investment and saving constrained economies
Source: Rodrik and Subramanian (2009, 132)
However, the situation of an investmentconstrained economy is even worst in the presence of
financial globalization, since inflow of capital appreciates local currency and that is bad for
the producers of tradables. They simply reduce their investments (shift of the investment
schedule from I to I1 in Figure 2b). On the other hand, an appreciation is a good news for the
producers of nontradables, however, from the economic growth standpoint what is important
is the situation of the producers of tradables. For the sake of simplicity, in this paper, we are
not to analyze the effects of appreciation as a response to the financial globalization (i.e.,
shifts of investment schedule without changing its slope), but rather we are interested in the
impact of institutional settings on the elasticity of investments to the changes in interest rate
(i.e., the slop of the investment schedule).
The lesson from the Rodrik’s study is straightforward: the response of a given
economy to the financial globalization depends largely on the quality of its institutional
framework. However, at least two issues should be clarified. First, in the real world most
economies are inbetween the two extremes described by Rodrik. Second, what is lacking is a
clear conceptualization of a positive institutional change which may contribute for making
investments’ demand more elastic with respect to the changes of the interest rate (access to
capital). In the next part of the paper we first try to show how a positive institutional change
can be conceptualized in the Rodrik’s framework and second we analyze the very
S, I S, I
I1 I
S S
S S I
I
r1
r0 r0
r1
Domestic supply of investible resources
Domestic investment demand for tradables
r r
Domestic supply of investible resources
Domestic investment demand for tradables
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
WORKING PAPER No. 96 15
3
12
characteristics of such a change. In other words, we want to add institutions into the
mechanics of transmission channels.
The majority of countries are not 100% investment constrained nor saving constrained, they
simply vary in terms of the elasticity of domestic investment demand to the changes in
interest rate (access to capital). In other words, they differ in the slope of domestic investment
demand curve. The more vertical the investment demand schedule, the more investment
constrained the economy is. Since the slope of that schedule depends on the availability of
investment opportunities, one can conclude that the higher the number of such opportunities,
the more horizontal that schedule is. Here we claim that the number of business opportunities
depends partly on the quality of institutional environment in which firms and individuals
function. The higher the quality is, ceteris paribus, the more elastic the investment schedule
(Figure 3).
Figure 3. Quality of institutions and the elasticity of investments
Source: Own reseach
Initially the economy is in (r0, i1), after a decline in the interest rate r0 r1 the economy can
arrive at (r1, i2) or (r1, i3); in the latter case investments are more elastic to the changes in
interest rate. We may say that, ceteris paribus, what causes the divergence is the difference in
the quality of institutions: better ones simply make investments more elastic. That offers an
interesting perspective to those responsible for making economic policy. If in a nearly totally
investment constrained economy we want to boost our investments, we should make
i1 i2 i3 S, I
r0
r1
r Domestic supply of investible resources
Domestic investment demand for tradables (good institutions) Domestic investment
demand for tradables (bad institutions)
13
investments more elastic to the growing access to capital (lower interest rate). That is not the
issue only of developing countries, but also of countries facing a growing inflow of external
funds, e.g., Poland with its EU’s transfers6. But also of Poland as a prospective member of the
EMU, since what is often claimed is that one of the advantages of Polish accession to the
Euro zone is the integration of EU’s financial markets7. However, if Poland is closer to the
investment constrained economy than to the saving constrained one, then the GDP stimulating
effect of joining the EMU (due to financial “globalization”) would not be significant8. A
detailed analysis and econometric estimation of the elasticity of investments to the changes in
access to capital is beyond the scope of this paper, however, such a study is more than
advisable. Here our aim is just to offer a conceptualization of the interplay between monetary
and regulatory policy, however, before doing so we need to conceptualize the interplay
between institutions and TCs. We do it in the next section.
We have stated earlier that what makes an economy an investment constrained is the low
quality of its institutions and regulations. A necessary condition for good institutions is that
they should “reduce uncertainty by establishing a stable (but not necessarily efficient)
structure to human interaction” (North 1990, 6); also “institutions, together with the standard
constraints of economic theory, determine the opportunities in a society” (ibid., 7). However,
one can have a stable institutional structure which is at the same time not efficient. Thus the
stability of that structure is only a necessary condition for efficiency of institutions. Therefore,
a sufficient condition for relative efficiency of a given institution is that it should reduce TCs.
Thus, institutions determine the level of transaction costs. This mechanism is twofold: first,
high TCs make possible transactions unrealizable; second, by limiting the exchange 6 In the public debate in Poland we often discuss the issue of the effectiveness of EU funds absorption, i.e., we are asking whether the allocation of EU funds under given institutional settings is optimal, however, we may ask not only whether the allocation is optimal, but also whether institutional settings are optimal for a given problem to solve. E.g., EU is investing in Polish SMEs in order to create new workplaces. These investments can give, e.g., 100000 new jobs in 5 years perspective. However, in the situation of better institutions (transparent and stable tax system, low administrative costs of running a business, etc.) the same investments can give more jobs. That is why it is useful to distinguish between technological effectiveness (getting allocation of resources right) and institutional effectiveness (getting allocation of resources right under optimal institutional settings) (cf. Green and Sheshinski 1975). We will come back to that issue later. 7 See, e.g., Raport na temat pełnego uczestnictwa Rzeczypospolitej Polskiej w trzecim etapie Unii Gospodarczej i Walutowej [Report on the consequences of full participation of Poland in the third stage of Economic and Monetary Union], National Bank of Poland, 2009, e.g., chapter 3.4. 8 According to many international studies the quality of institutions in Poland is very low (see e.g., Doing Business by World Bank, Economic Freedom Indexes /Fraser Institute and Heritage Foundation/, etc.). E.g., very recently Poland was ranked 41 in The Transparency International Report Corruption Perception Indexes 2010.
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
N a t i o n a l B a n k o f P o l a n d16
3
13
investments more elastic to the growing access to capital (lower interest rate). That is not the
issue only of developing countries, but also of countries facing a growing inflow of external
funds, e.g., Poland with its EU’s transfers6. But also of Poland as a prospective member of the
EMU, since what is often claimed is that one of the advantages of Polish accession to the
Euro zone is the integration of EU’s financial markets7. However, if Poland is closer to the
investment constrained economy than to the saving constrained one, then the GDP stimulating
effect of joining the EMU (due to financial “globalization”) would not be significant8. A
detailed analysis and econometric estimation of the elasticity of investments to the changes in
access to capital is beyond the scope of this paper, however, such a study is more than
advisable. Here our aim is just to offer a conceptualization of the interplay between monetary
and regulatory policy, however, before doing so we need to conceptualize the interplay
between institutions and TCs. We do it in the next section.
We have stated earlier that what makes an economy an investment constrained is the low
quality of its institutions and regulations. A necessary condition for good institutions is that
they should “reduce uncertainty by establishing a stable (but not necessarily efficient)
structure to human interaction” (North 1990, 6); also “institutions, together with the standard
constraints of economic theory, determine the opportunities in a society” (ibid., 7). However,
one can have a stable institutional structure which is at the same time not efficient. Thus the
stability of that structure is only a necessary condition for efficiency of institutions. Therefore,
a sufficient condition for relative efficiency of a given institution is that it should reduce TCs.
Thus, institutions determine the level of transaction costs. This mechanism is twofold: first,
high TCs make possible transactions unrealizable; second, by limiting the exchange 6 In the public debate in Poland we often discuss the issue of the effectiveness of EU funds absorption, i.e., we are asking whether the allocation of EU funds under given institutional settings is optimal, however, we may ask not only whether the allocation is optimal, but also whether institutional settings are optimal for a given problem to solve. E.g., EU is investing in Polish SMEs in order to create new workplaces. These investments can give, e.g., 100000 new jobs in 5 years perspective. However, in the situation of better institutions (transparent and stable tax system, low administrative costs of running a business, etc.) the same investments can give more jobs. That is why it is useful to distinguish between technological effectiveness (getting allocation of resources right) and institutional effectiveness (getting allocation of resources right under optimal institutional settings) (cf. Green and Sheshinski 1975). We will come back to that issue later. 7 See, e.g., Raport na temat pełnego uczestnictwa Rzeczypospolitej Polskiej w trzecim etapie Unii Gospodarczej i Walutowej [Report on the consequences of full participation of Poland in the third stage of Economic and Monetary Union], National Bank of Poland, 2009, e.g., chapter 3.4. 8 According to many international studies the quality of institutions in Poland is very low (see e.g., Doing Business by World Bank, Economic Freedom Indexes /Fraser Institute and Heritage Foundation/, etc.). E.g., very recently Poland was ranked 41 in The Transparency International Report Corruption Perception Indexes 2010.
13
investments more elastic to the growing access to capital (lower interest rate). That is not the
issue only of developing countries, but also of countries facing a growing inflow of external
funds, e.g., Poland with its EU’s transfers6. But also of Poland as a prospective member of the
EMU, since what is often claimed is that one of the advantages of Polish accession to the
Euro zone is the integration of EU’s financial markets7. However, if Poland is closer to the
investment constrained economy than to the saving constrained one, then the GDP stimulating
effect of joining the EMU (due to financial “globalization”) would not be significant8. A
detailed analysis and econometric estimation of the elasticity of investments to the changes in
access to capital is beyond the scope of this paper, however, such a study is more than
advisable. Here our aim is just to offer a conceptualization of the interplay between monetary
and regulatory policy, however, before doing so we need to conceptualize the interplay
between institutions and TCs. We do it in the next section.
We have stated earlier that what makes an economy an investment constrained is the low
quality of its institutions and regulations. A necessary condition for good institutions is that
they should “reduce uncertainty by establishing a stable (but not necessarily efficient)
structure to human interaction” (North 1990, 6); also “institutions, together with the standard
constraints of economic theory, determine the opportunities in a society” (ibid., 7). However,
one can have a stable institutional structure which is at the same time not efficient. Thus the
stability of that structure is only a necessary condition for efficiency of institutions. Therefore,
a sufficient condition for relative efficiency of a given institution is that it should reduce TCs.
Thus, institutions determine the level of transaction costs. This mechanism is twofold: first,
high TCs make possible transactions unrealizable; second, by limiting the exchange 6 In the public debate in Poland we often discuss the issue of the effectiveness of EU funds absorption, i.e., we are asking whether the allocation of EU funds under given institutional settings is optimal, however, we may ask not only whether the allocation is optimal, but also whether institutional settings are optimal for a given problem to solve. E.g., EU is investing in Polish SMEs in order to create new workplaces. These investments can give, e.g., 100000 new jobs in 5 years perspective. However, in the situation of better institutions (transparent and stable tax system, low administrative costs of running a business, etc.) the same investments can give more jobs. That is why it is useful to distinguish between technological effectiveness (getting allocation of resources right) and institutional effectiveness (getting allocation of resources right under optimal institutional settings) (cf. Green and Sheshinski 1975). We will come back to that issue later. 7 See, e.g., Raport na temat pełnego uczestnictwa Rzeczypospolitej Polskiej w trzecim etapie Unii Gospodarczej i Walutowej [Report on the consequences of full participation of Poland in the third stage of Economic and Monetary Union], National Bank of Poland, 2009, e.g., chapter 3.4. 8 According to many international studies the quality of institutions in Poland is very low (see e.g., Doing Business by World Bank, Economic Freedom Indexes /Fraser Institute and Heritage Foundation/, etc.). E.g., very recently Poland was ranked 41 in The Transparency International Report Corruption Perception Indexes 2010.
14
possibilities, high TCs deteriorate the functioning of the market what in the longrun results in
no investment possibilities at all (due to the low number of exchange interactions). In new
institutional economics (NIE) we can find plenty of statements that good institutions are the
ones that reduce TCs, e.g.:
“by treating the institutional environment as a locus of parameters, changes in which
parameters bring about shifts in the comparative costs of governance” (Williamson 1991,
269).
“Institutions affect economic performance by determining (together with the technology
employed) transaction and transformation (production) costs” (North 1993, 2)
“transaction costs are the costs that arise from the establishment, use, maintenance, and
change of: 1/ institutions in the sense of law; and 2/ institutions in the sense of rights”
(Furubotn and Richter 2000, 43)
“institutions and organizations seek to achieve efficiency, minimizing a comprehensive cost –
inclusive not merely of the neoclassical production cost, but also of transaction costs” (Dixit
1996, 58)
However, despite a strong believe that institutions reduce TCs, we find a very limited number
of more precise conceptualizations of the interplay between the two. That is due to a quite
imprecise nature of the concept of TCs; in fact we have many kinds of TCs (Hardt 2009,
2010). Since we are interested here in the market transaction costs, we will not analyze the
managerial costs of running firms, but rather we are to focus on the costs of making
transactions between independent enterprises on the market. But again, the notion of a market
transaction cost is not unambiguous. We define here three kinds of these costs: 1/ exante
TCs (costs incurred prior to the transaction); 2/ exchange costs (costs incurred while making
the transaction); 3/ expost TCs (costs of enforcing a contract). So, the total TCs is the sum of
these three. Moreover, there are a lot of interplays not only between TCs and institutions but
also between various kinds of TCs. We start building our framework by referring to the very
basic conceptualization by Martens (2004) who claims that there is a tradeoff between ex
ante and expost TCs, and the “shape” of that tradeoff depends on the quality of institutions.
It simply goes as follows: the more you invest before the transaction (e.g., you employ a very
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
WORKING PAPER No. 96 17
3
14
possibilities, high TCs deteriorate the functioning of the market what in the longrun results in
no investment possibilities at all (due to the low number of exchange interactions). In new
institutional economics (NIE) we can find plenty of statements that good institutions are the
ones that reduce TCs, e.g.:
“by treating the institutional environment as a locus of parameters, changes in which
parameters bring about shifts in the comparative costs of governance” (Williamson 1991,
269).
“Institutions affect economic performance by determining (together with the technology
employed) transaction and transformation (production) costs” (North 1993, 2)
“transaction costs are the costs that arise from the establishment, use, maintenance, and
change of: 1/ institutions in the sense of law; and 2/ institutions in the sense of rights”
(Furubotn and Richter 2000, 43)
“institutions and organizations seek to achieve efficiency, minimizing a comprehensive cost –
inclusive not merely of the neoclassical production cost, but also of transaction costs” (Dixit
1996, 58)
However, despite a strong believe that institutions reduce TCs, we find a very limited number
of more precise conceptualizations of the interplay between the two. That is due to a quite
imprecise nature of the concept of TCs; in fact we have many kinds of TCs (Hardt 2009,
2010). Since we are interested here in the market transaction costs, we will not analyze the
managerial costs of running firms, but rather we are to focus on the costs of making
transactions between independent enterprises on the market. But again, the notion of a market
transaction cost is not unambiguous. We define here three kinds of these costs: 1/ exante
TCs (costs incurred prior to the transaction); 2/ exchange costs (costs incurred while making
the transaction); 3/ expost TCs (costs of enforcing a contract). So, the total TCs is the sum of
these three. Moreover, there are a lot of interplays not only between TCs and institutions but
also between various kinds of TCs. We start building our framework by referring to the very
basic conceptualization by Martens (2004) who claims that there is a tradeoff between ex
ante and expost TCs, and the “shape” of that tradeoff depends on the quality of institutions.
It simply goes as follows: the more you invest before the transaction (e.g., you employ a very
15
good lawyer who checks the legal status of a parcel you are to buy), the less you pay after
transaction (e.g., the litigation costs). One should note that exante TCs are the paid costs and
expost TCs are potential costs9. In a sense expost TCs are treated here as a proxy for risk.
Figure 4. The interplay between expost and exante TCs
Source: Martens (2004, 112)
In this framework a positive institutional change is conceptualized as a shift of Institution A
curve (the curve representing a given institutional framework) towards the origin (here to the
position depicted as Institution B). It is worth noting that an institutional change is a move of
the curve and not on the curve, e.g., if one invests TC1exante for a lawyer checking the legal
status of a parcel before transaction, with Institution A (e.g., weakly defined property rights),
he risks paying TC1expost after transaction. However, if we have an institutional change (e.g.,
now property rights are well defined and land registry is accessible via Internet), then
investing TC1exante enables us to reduce expost TCs to TC2
expost. Thus what matters is a
reduction of total TCs. What clearly follows is an important role for economic policy. As
Dixit points out:
“There is clear potential benefit from economizing on transaction costs. Rules and institutions
should, and do, evolve to serve this purpose” (Dixit 1996, 61)10.
9 For the simplification of our arguments we treat expost TCs as paid costs and also we equalize exchange costs (costs incurred while making the transaction) to zero, e.g., bank transfers’ fees. 10 The same was stated by Adam Smith in his The Wealth of the Nations: “Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do
TC2expost TC1
expost TC expost
Institutional change
Institution A
Institution B
TC exante
TC1exante
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
N a t i o n a l B a n k o f P o l a n d18
3
15
good lawyer who checks the legal status of a parcel you are to buy), the less you pay after
transaction (e.g., the litigation costs). One should note that exante TCs are the paid costs and
expost TCs are potential costs9. In a sense expost TCs are treated here as a proxy for risk.
Figure 4. The interplay between expost and exante TCs
Source: Martens (2004, 112)
In this framework a positive institutional change is conceptualized as a shift of Institution A
curve (the curve representing a given institutional framework) towards the origin (here to the
position depicted as Institution B). It is worth noting that an institutional change is a move of
the curve and not on the curve, e.g., if one invests TC1exante for a lawyer checking the legal
status of a parcel before transaction, with Institution A (e.g., weakly defined property rights),
he risks paying TC1expost after transaction. However, if we have an institutional change (e.g.,
now property rights are well defined and land registry is accessible via Internet), then
investing TC1exante enables us to reduce expost TCs to TC2
expost. Thus what matters is a
reduction of total TCs. What clearly follows is an important role for economic policy. As
Dixit points out:
“There is clear potential benefit from economizing on transaction costs. Rules and institutions
should, and do, evolve to serve this purpose” (Dixit 1996, 61)10.
9 For the simplification of our arguments we treat expost TCs as paid costs and also we equalize exchange costs (costs incurred while making the transaction) to zero, e.g., bank transfers’ fees. 10 The same was stated by Adam Smith in his The Wealth of the Nations: “Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do
TC2expost TC1
expost TC expost
Institutional change
Institution A
Institution B
TC exante
TC1exante
15
good lawyer who checks the legal status of a parcel you are to buy), the less you pay after
transaction (e.g., the litigation costs). One should note that exante TCs are the paid costs and
expost TCs are potential costs9. In a sense expost TCs are treated here as a proxy for risk.
Figure 4. The interplay between expost and exante TCs
Source: Martens (2004, 112)
In this framework a positive institutional change is conceptualized as a shift of Institution A
curve (the curve representing a given institutional framework) towards the origin (here to the
position depicted as Institution B). It is worth noting that an institutional change is a move of
the curve and not on the curve, e.g., if one invests TC1exante for a lawyer checking the legal
status of a parcel before transaction, with Institution A (e.g., weakly defined property rights),
he risks paying TC1expost after transaction. However, if we have an institutional change (e.g.,
now property rights are well defined and land registry is accessible via Internet), then
investing TC1exante enables us to reduce expost TCs to TC2
expost. Thus what matters is a
reduction of total TCs. What clearly follows is an important role for economic policy. As
Dixit points out:
“There is clear potential benefit from economizing on transaction costs. Rules and institutions
should, and do, evolve to serve this purpose” (Dixit 1996, 61)10.
9 For the simplification of our arguments we treat expost TCs as paid costs and also we equalize exchange costs (costs incurred while making the transaction) to zero, e.g., bank transfers’ fees. 10 The same was stated by Adam Smith in his The Wealth of the Nations: “Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do
TC2expost TC1
expost TC expost
Institutional change
Institution A
Institution B
TC exante
TC1exante
16
So, the first conclusion for regulatory actions of the government can be the following: an
institutional change which diminishes expost TCs for a given level of exante TCs can be
treated as a positive regulatory reform. Importantly, if we put into our framework exchange
costs (expenses paid at the moment of transaction), a very common kind of TCs on the
financial markets, then a change in the amount of these costs per se does not necessarily
signifies an institutional change (e.g., a decline in bank’s commission for transferring money).
However, such a change can result from institutional change in the financial market, e.g., a
new law introducing a more competitive financial markets and hence making reductions of
banks’ commissions more probable.
Now, let’s make our model a bit more complex, however, we still subscribe to our
idealization of zero exchange costs in the very moment of transaction. The question we ask
now is the following: if we have a set of agents in a given economy making transactions using
a given institution, do each of them face the same institutional framework curve? The answer
is no, since each has a different experience. So, let’s have two agents: an experienced one and
the second inexperienced. In a buying a parcel example an experienced one is the one with
many years in this business, he knows possible risks very well, since many times in the past
he incurred high expost TCs resulting from bad deals. Thus the more transactions he made in
the past, the less expost TCs he has to pay, for a given exante TCs, in the future. His
situation is presented in the Figure 5, where N is for the number of transactions in the past.
not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law, and in which the authority of the state is not supposed to be regularly employed in forcing the payment of debts from all those who are able to pay. Commerce and manufactures in short, can seldom flourish in any state in which there is not a certain degree of confidence in the justice of government” (Book 5, Ch. 3, par. 7).
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
WORKING PAPER No. 96 19
3
16
So, the first conclusion for regulatory actions of the government can be the following: an
institutional change which diminishes expost TCs for a given level of exante TCs can be
treated as a positive regulatory reform. Importantly, if we put into our framework exchange
costs (expenses paid at the moment of transaction), a very common kind of TCs on the
financial markets, then a change in the amount of these costs per se does not necessarily
signifies an institutional change (e.g., a decline in bank’s commission for transferring money).
However, such a change can result from institutional change in the financial market, e.g., a
new law introducing a more competitive financial markets and hence making reductions of
banks’ commissions more probable.
Now, let’s make our model a bit more complex, however, we still subscribe to our
idealization of zero exchange costs in the very moment of transaction. The question we ask
now is the following: if we have a set of agents in a given economy making transactions using
a given institution, do each of them face the same institutional framework curve? The answer
is no, since each has a different experience. So, let’s have two agents: an experienced one and
the second inexperienced. In a buying a parcel example an experienced one is the one with
many years in this business, he knows possible risks very well, since many times in the past
he incurred high expost TCs resulting from bad deals. Thus the more transactions he made in
the past, the less expost TCs he has to pay, for a given exante TCs, in the future. His
situation is presented in the Figure 5, where N is for the number of transactions in the past.
not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law, and in which the authority of the state is not supposed to be regularly employed in forcing the payment of debts from all those who are able to pay. Commerce and manufactures in short, can seldom flourish in any state in which there is not a certain degree of confidence in the justice of government” (Book 5, Ch. 3, par. 7).
17
Figure 5. Expost TCs as a function of institutional framework and the experience of an agent
Source: Own research
We may have agents who cope relatively well with bad institutional settings, since they use
well the principle of learning by doing. Now, let’s imagine that an inexperienced agent wants
to make a transaction (here his tradeoff between exante and expost TCs is described with a
curve N=0). He knows that there is an agent with tradeoff N=15, so he may try not to make a
transaction on his own but rather he may buy transaction services from the experienced one. If
he makes his transaction without intermediation, he pays TC1exante+ TC1
expost, so for him it is
better to pay the experienced agent TC for intermediation (TCI) with
TCI <(TC1exante+ TC1
expost) (we call TC1expost – TC4
expost as a transaction premium due to
experience; so the experienced agent pays TC1exante + TC4
expost and he can charge an
inexperienced one with a fare that is less than transaction premium due to experience)11.
Transaction experienced agents are easily findable in the market economy and they range
from individuals helping people in buying used cars to the big law firms. They make huge
profits for high values of transaction premium due to experience. Unfortunately, in low
quality institutions countries these transaction experienced agents quite often use illegal
methods for transactions’ intermediary. Consequently, they oppose any regulatory reforms
aiming at lowering the general level of TCs in a given economy12. Another argument
explaining the ineffectiveness of building good formal institutions in developing countries
was given by Dixit (2004), who claims that costs of building such institutions are quite high 11 Here we assume that there is no costs of transferring goods between two agents. 12 Also, in case of developed countries the transaction experienced agents may use legal methods (e.g., lobbying) in order to stop regulatory changes aiming at making institutions more efficient.
TC4expost TC1expost TC expost
TC exante
TC1exante
N=0 N=5 N=10
N=15
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
N a t i o n a l B a n k o f P o l a n d20
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17
Figure 5. Expost TCs as a function of institutional framework and the experience of an agent
Source: Own research
We may have agents who cope relatively well with bad institutional settings, since they use
well the principle of learning by doing. Now, let’s imagine that an inexperienced agent wants
to make a transaction (here his tradeoff between exante and expost TCs is described with a
curve N=0). He knows that there is an agent with tradeoff N=15, so he may try not to make a
transaction on his own but rather he may buy transaction services from the experienced one. If
he makes his transaction without intermediation, he pays TC1exante+ TC1
expost, so for him it is
better to pay the experienced agent TC for intermediation (TCI) with
TCI <(TC1exante+ TC1
expost) (we call TC1expost – TC4
expost as a transaction premium due to
experience; so the experienced agent pays TC1exante + TC4
expost and he can charge an
inexperienced one with a fare that is less than transaction premium due to experience)11.
Transaction experienced agents are easily findable in the market economy and they range
from individuals helping people in buying used cars to the big law firms. They make huge
profits for high values of transaction premium due to experience. Unfortunately, in low
quality institutions countries these transaction experienced agents quite often use illegal
methods for transactions’ intermediary. Consequently, they oppose any regulatory reforms
aiming at lowering the general level of TCs in a given economy12. Another argument
explaining the ineffectiveness of building good formal institutions in developing countries
was given by Dixit (2004), who claims that costs of building such institutions are quite high 11 Here we assume that there is no costs of transferring goods between two agents. 12 Also, in case of developed countries the transaction experienced agents may use legal methods (e.g., lobbying) in order to stop regulatory changes aiming at making institutions more efficient.
TC4expost TC1expost TC expost
TC exante
TC1exante
N=0 N=5 N=10
N=15
17
Figure 5. Expost TCs as a function of institutional framework and the experience of an agent
Source: Own research
We may have agents who cope relatively well with bad institutional settings, since they use
well the principle of learning by doing. Now, let’s imagine that an inexperienced agent wants
to make a transaction (here his tradeoff between exante and expost TCs is described with a
curve N=0). He knows that there is an agent with tradeoff N=15, so he may try not to make a
transaction on his own but rather he may buy transaction services from the experienced one. If
he makes his transaction without intermediation, he pays TC1exante+ TC1
expost, so for him it is
better to pay the experienced agent TC for intermediation (TCI) with
TCI <(TC1exante+ TC1
expost) (we call TC1expost – TC4
expost as a transaction premium due to
experience; so the experienced agent pays TC1exante + TC4
expost and he can charge an
inexperienced one with a fare that is less than transaction premium due to experience)11.
Transaction experienced agents are easily findable in the market economy and they range
from individuals helping people in buying used cars to the big law firms. They make huge
profits for high values of transaction premium due to experience. Unfortunately, in low
quality institutions countries these transaction experienced agents quite often use illegal
methods for transactions’ intermediary. Consequently, they oppose any regulatory reforms
aiming at lowering the general level of TCs in a given economy12. Another argument
explaining the ineffectiveness of building good formal institutions in developing countries
was given by Dixit (2004), who claims that costs of building such institutions are quite high 11 Here we assume that there is no costs of transferring goods between two agents. 12 Also, in case of developed countries the transaction experienced agents may use legal methods (e.g., lobbying) in order to stop regulatory changes aiming at making institutions more efficient.
TC4expost TC1expost TC expost
TC exante
TC1exante
N=0 N=5 N=10
N=15
18
and hence it is often better to leave the agents with relational contracting as the only
possibility. That argument is also present in Rodrik’s 2008 paper where he claims that in
developing countries:
“it is more effective to enhance relational contracting—for example by improving information
gathering and dissemination about the reputation of firms—than to invest (at the current stage
of a country’s development at least) in firstclass legal institutions” (Rodrik 2008a, 5)
In our framework “improving information gathering and dissemination about the reputation of
firms” simply means to ease the access to transaction experienced agents. Thus transacting
parties do not need to establish personal relations between them but rather to use services of
an entity specialized in organizing transactions. Law merchants in medieval Europe served
that role (North 1990) and now various institutions collecting information about dishonest
contractors do pretty much the same.
In the case of developed countries, with low level of corruption, the situation is
different: the government can reform the institutions (a move of an institutional framework
curve to the origin) or it can ease the access of transacting parties to the transaction
experienced agents13. Reforming institutions is often costly, since the government has to buy a
consent of many groups of stakeholders losing revenues as a result of the reform. So,
sometimes the better idea is to make the market of transaction experienced agents more
effective, e.g., by guarantying the competition between them. Another possibility the
government can have is to stimulate the accumulation of social capital, however, the results of
this are in the longrun14. In most cases the governments should do the three simultaneously:
1/ reforming institutions; 2/ making the market of transaction experienced agents more
effective; 3/ mobilizing social capital.
Now, let’s make a step further. What we claim is that not only the TCs per se matter,
but what matters is their size in the relation to the budget constraint of the consumer. If TCs
are relatively small in relation to the price of good the consumer is to buy, then they do not
pose a huge constraint on the consumer. Therefore, what we need is to put TCs into a standard
decision problem of a consumer. We do it using a modified conceptualization from Niehans
13 We do not claim here the high level of GDP per capita alone guarantees the low level of corruption. However, in most cases, there is a statistically significant positive correlation between corruption perception index (e.g., the one measured by Transparency International) and the GDP growth rates, i.e., the lower level of perceived corruption, the higher GDP growth (see, e.g., Svensson 2005). 14 Here the assumption is that high levels of social capital are negatively correlated with TCs.
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
WORKING PAPER No. 96 21
3
18
and hence it is often better to leave the agents with relational contracting as the only
possibility. That argument is also present in Rodrik’s 2008 paper where he claims that in
developing countries:
“it is more effective to enhance relational contracting—for example by improving information
gathering and dissemination about the reputation of firms—than to invest (at the current stage
of a country’s development at least) in firstclass legal institutions” (Rodrik 2008a, 5)
In our framework “improving information gathering and dissemination about the reputation of
firms” simply means to ease the access to transaction experienced agents. Thus transacting
parties do not need to establish personal relations between them but rather to use services of
an entity specialized in organizing transactions. Law merchants in medieval Europe served
that role (North 1990) and now various institutions collecting information about dishonest
contractors do pretty much the same.
In the case of developed countries, with low level of corruption, the situation is
different: the government can reform the institutions (a move of an institutional framework
curve to the origin) or it can ease the access of transacting parties to the transaction
experienced agents13. Reforming institutions is often costly, since the government has to buy a
consent of many groups of stakeholders losing revenues as a result of the reform. So,
sometimes the better idea is to make the market of transaction experienced agents more
effective, e.g., by guarantying the competition between them. Another possibility the
government can have is to stimulate the accumulation of social capital, however, the results of
this are in the longrun14. In most cases the governments should do the three simultaneously:
1/ reforming institutions; 2/ making the market of transaction experienced agents more
effective; 3/ mobilizing social capital.
Now, let’s make a step further. What we claim is that not only the TCs per se matter,
but what matters is their size in the relation to the budget constraint of the consumer. If TCs
are relatively small in relation to the price of good the consumer is to buy, then they do not
pose a huge constraint on the consumer. Therefore, what we need is to put TCs into a standard
decision problem of a consumer. We do it using a modified conceptualization from Niehans
13 We do not claim here the high level of GDP per capita alone guarantees the low level of corruption. However, in most cases, there is a statistically significant positive correlation between corruption perception index (e.g., the one measured by Transparency International) and the GDP growth rates, i.e., the lower level of perceived corruption, the higher GDP growth (see, e.g., Svensson 2005). 14 Here the assumption is that high levels of social capital are negatively correlated with TCs.
18
and hence it is often better to leave the agents with relational contracting as the only
possibility. That argument is also present in Rodrik’s 2008 paper where he claims that in
developing countries:
“it is more effective to enhance relational contracting—for example by improving information
gathering and dissemination about the reputation of firms—than to invest (at the current stage
of a country’s development at least) in firstclass legal institutions” (Rodrik 2008a, 5)
In our framework “improving information gathering and dissemination about the reputation of
firms” simply means to ease the access to transaction experienced agents. Thus transacting
parties do not need to establish personal relations between them but rather to use services of
an entity specialized in organizing transactions. Law merchants in medieval Europe served
that role (North 1990) and now various institutions collecting information about dishonest
contractors do pretty much the same.
In the case of developed countries, with low level of corruption, the situation is
different: the government can reform the institutions (a move of an institutional framework
curve to the origin) or it can ease the access of transacting parties to the transaction
experienced agents13. Reforming institutions is often costly, since the government has to buy a
consent of many groups of stakeholders losing revenues as a result of the reform. So,
sometimes the better idea is to make the market of transaction experienced agents more
effective, e.g., by guarantying the competition between them. Another possibility the
government can have is to stimulate the accumulation of social capital, however, the results of
this are in the longrun14. In most cases the governments should do the three simultaneously:
1/ reforming institutions; 2/ making the market of transaction experienced agents more
effective; 3/ mobilizing social capital.
Now, let’s make a step further. What we claim is that not only the TCs per se matter,
but what matters is their size in the relation to the budget constraint of the consumer. If TCs
are relatively small in relation to the price of good the consumer is to buy, then they do not
pose a huge constraint on the consumer. Therefore, what we need is to put TCs into a standard
decision problem of a consumer. We do it using a modified conceptualization from Niehans
13 We do not claim here the high level of GDP per capita alone guarantees the low level of corruption. However, in most cases, there is a statistically significant positive correlation between corruption perception index (e.g., the one measured by Transparency International) and the GDP growth rates, i.e., the lower level of perceived corruption, the higher GDP growth (see, e.g., Svensson 2005). 14 Here the assumption is that high levels of social capital are negatively correlated with TCs.
19
(1971). We assume that there is only one consumer choosing between two goods; he is facing
a budget constraint (Figure 6). His initial endowment is E. Trade can take place along the
straight line through E whose slope measures the market price of good 1 in terms of good 2.
However, with positive TCs, the commodity bundle resulting from trade is not fully available
for consumption. The exact consumption frontier is AEB. TCs, if paid in good 2, are measured
as a vertical distance between the consumption frontier and the trade line. The point consumer
is choosing is C (the point of tangency of U1 to the segment EB). If TCs are high enough
(higher than the price of good 1 in terms of good 2), then no trade occurs.
Figure 6. TCs and the welfare of the consumer
Source: Modified analysis from Niehans (1971)
What happens if we have a change in the level of TCs? If TCs are diminished (consumption
frontier changes to A`EB`), then consumer is betteroff (he moves from C to C`, where C` is
the point of tangency of U3 to the segment EB`). What follows is that institutional reforms
should be performed in situations of high TCs and especially when TCs are so high that they
block the trade at all. Using the Figure 6 the notrade situation can be modeled as follows: the
initial endowment is E and TCs are so high (budget constraint is AES ) that the optimal point,
after a change in institutions, is still E, a nontrade point.
For the sake of simplicity we assumed that expost TCs are in fact paid costs and that
agents do not differ in their risk aversion. Also, we made an assumption that intertemporal
interest rate is zero (interest rate between the time when incurring exante and expost TCs).
C
C`
U3 U2
U1 19
(1971). We assume that there is only one consumer choosing between two goods; he is facing
a budget constraint (Figure 6). His initial endowment is E. Trade can take place along the
straight line through E whose slope measures the market price of good 1 in terms of good 2.
However, with positive TCs, the commodity bundle resulting from trade is not fully available
for consumption. The exact consumption frontier is AEB. TCs, if paid in good 2, are measured
as a vertical distance between the consumption frontier and the trade line. The point consumer
is choosing is C (the point of tangency of U1 to the segment EB). If TCs are high enough
(higher than the price of good 1 in terms of good 2), then no trade occurs.
Figure 6. TCs and the welfare of the consumer
Source: Modified analysis from Niehans (1971)
What happens if we have a change in the level of TCs? If TCs are diminished (consumption
frontier changes to A`EB`), then consumer is betteroff (he moves from C to C`, where C` is
the point of tangency of U3 to the segment EB`). What follows is that institutional reforms
should be performed in situations of high TCs and especially when TCs are so high that they
block the trade at all. Using the Figure 6 the notrade situation can be modeled as follows: the
initial endowment is E and TCs are so high (budget constraint is AES ) that the optimal point,
after a change in institutions, is still E, a nontrade point.
For the sake of simplicity we assumed that expost TCs are in fact paid costs and that
agents do not differ in their risk aversion. Also, we made an assumption that intertemporal
interest rate is zero (interest rate between the time when incurring exante and expost TCs).
C
C`
U3 U2
U1
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
N a t i o n a l B a n k o f P o l a n d22
3
19
(1971). We assume that there is only one consumer choosing between two goods; he is facing
a budget constraint (Figure 6). His initial endowment is E. Trade can take place along the
straight line through E whose slope measures the market price of good 1 in terms of good 2.
However, with positive TCs, the commodity bundle resulting from trade is not fully available
for consumption. The exact consumption frontier is AEB. TCs, if paid in good 2, are measured
as a vertical distance between the consumption frontier and the trade line. The point consumer
is choosing is C (the point of tangency of U1 to the segment EB). If TCs are high enough
(higher than the price of good 1 in terms of good 2), then no trade occurs.
Figure 6. TCs and the welfare of the consumer
Source: Modified analysis from Niehans (1971)
What happens if we have a change in the level of TCs? If TCs are diminished (consumption
frontier changes to A`EB`), then consumer is betteroff (he moves from C to C`, where C` is
the point of tangency of U3 to the segment EB`). What follows is that institutional reforms
should be performed in situations of high TCs and especially when TCs are so high that they
block the trade at all. Using the Figure 6 the notrade situation can be modeled as follows: the
initial endowment is E and TCs are so high (budget constraint is AES ) that the optimal point,
after a change in institutions, is still E, a nontrade point.
For the sake of simplicity we assumed that expost TCs are in fact paid costs and that
agents do not differ in their risk aversion. Also, we made an assumption that intertemporal
interest rate is zero (interest rate between the time when incurring exante and expost TCs).
C
C`
U3 U2
U1
20
What happens when we have a positive and high interest rate, and there is a possibility that
expost TCs would not realize (e.g., I can be a lucky buyer and I can buy a parcel without any
law defect)? Now, an agent thinks as follows: I want to make a transaction, so I have to pay
some TCs, however, since interest rate is high maybe it would be better not to pay high ex
ante TCs but rather to invest money into profitable capital assets. Let’s have an intertemporal
interest rate of 30%. In order to make a deal our consumer should pay some TCs. He knows
that if he invests 100$ before transaction (exante TCs), then he will face expost TCs of 20$
with probability, p=0,2, and 0$ with p=0,8 (instead of 20$ with p=0,8 and 0$ with p=0,2 for
exante TCs=0). Thus investing 100$ exante diminishes his expected expost TCs from 16$
to 4$, so he saves 12$, however, investing 100$ on the market with 30% interest rate gives
him 30$. For sure it is better to put money into the bank account and not to pay high exante
TCs. Now, what happens if there is a decline in the interest rate to 10%? If he is a risklover,
he should invest and not to pay exante TCs. However, if the majority of consumers are risk
averse (or neutral), then they move from investing money into bank accounts (or some capital
assets) to pay exante TCs. Let’s assume that people generally do not like risk, so a decline in
the interest rate makes them use the institutions enabling transactions. That matters especially
for the savingconstrained economies. If interest rates are high, then people may not be
interested in the shape of the tradeoff between exante and expost TCs, because they are
betteroff while putting money into the bank account even if they have to pay expost TCs. If
it is so, then institutional fabric of the society may deteriorate. Therefore, financial
globalization may have a positive effect on the savingconstrained economies, since it often
makes using transaction services necessary and hence it stimulate people to think why a trade
off is such or such. What follows is that they will try to induce, or at least think of, regulatory
reforms. Now, after discussing the role of institutions and their potential effects on the extent
to which monetary policy affects economy, we come back to basic transmission mechanisms
described in section 2 and we show how institutional changes can be integrated into that
framework.
The interest credit channel. Here we want to check to what extent the transmission
mechanisms presented earlier are sensitive to changes in institutional settings. In fact, in our
discussion on financial globalization we referred to the interest rate channel. So, the effect of
a decline in M can be more negative to changes in Y in case of deteriorating institutions. And,
Do institutions really matter for monetary transmission? Some empirical and theoretical insights
WORKING PAPER No. 96 23
3
20
What happens when we have a positive and high interest rate, and there is a possibility that
expost TCs would not realize (e.g., I can be a lucky buyer and I can buy a parcel without any
law defect)? Now, an agent thinks as follows: I want to make a transaction, so I have to pay
some TCs, however, since interest rate is high maybe it would be better not to pay high ex
ante TCs but rather to invest money into profitable capital assets. Let’s have an intertemporal
interest rate of 30%. In order to make a deal our consumer should pay some TCs. He knows
that if he invests 100$ before transaction (exante TCs), then he will face expost TCs of 20$
with probability, p=0,2, and 0$ with p=0,8 (instead of 20$ with p=0,8 and 0$ with p=0,2 for
exante TCs=0). Thus investing 100$ exante diminishes his expected expost TCs from 16$
to 4$, so he saves 12$, however, investing 100$ on the market with 30% interest rate gives
him 30$. For sure it is better to put money into the bank account and not to pay high exante
TCs. Now, what happens if there is a decline in the interest rate to 10%? If he is a risklover,
he should invest and not to pay exante TCs. However, if the majority of consumers are risk
averse (or neutral), then they move from investing money into bank accounts (or some capital
assets) to pay exante TCs. Let’s assume that people generally do not like risk, so a decline in
the interest rate makes them use the institutions enabling transactions. That matters especially
for the savingconstrained economies. If interest rates are high, then people may not be
interested in the shape of the tradeoff between exante and expost TCs, because they are
betteroff while putting money into the bank account even if they have to pay expost TCs. If
it is so, then institutional fabric of the society may deteriorate. Therefore, financial
globalization may have a positive effect on the savingconstrained economies, since it often
makes using transaction services necessary and hence it stimulate people to think why a trade
off is such or such. What follows is that they will try to induce, or at least think of, regulatory
reforms. Now, after discussing the role of institutions and their potential effects on the extent
to which monetary policy affects economy, we come back to basic transmission mechanisms
described in section 2 and we show how institutional changes can be integrated into that
framework.
The interest credit channel. Here we want to check to what extent the transmission
mechanisms presented earlier are sensitive to changes in institutional settings. In fact, in our
discussion on financial globalization we referred to the interest rate channel. So, the effect of
a decline in M can be more negative to changes in Y in case of deteriorating institutions. And,
Putting institutions into transmission mechanisms
N a t i o n a l B a n k o f P o l a n d24
4
21
on the contrary, a decline in M but combined with a positive regulatory reform does not
necessarily lead to a decline in Y (subscript u stands for an unchanged variable and the
number of arrows describes the magnitude of change of a variable in question) and even can
be associated with a rise in Y. Systematically, we can write it down as follows:
Deteriorating institutions: M ↓ => i ↑ => I ↓↓ => Y ↓↓,
No change in institutions: M ↓ => i ↑ => I ↓ => Y ↓,
Positive regulatory reform: M ↓ => i ↑ => Iu (or I ↑) (or I ↓)15 => Yu (or Y ↑) (or Y ↓),
We claim here that institutional changes matter for firms’ and consumers’ behavior. If, for
instance, there is a rise in M leading to a decline in i and hence making consumers more
willing to buy houses, but, if, simultaneously, government is introducing a new law making
acquisition of private property by a public authority easier (e.g., when government wants to
acquire land for a new road), then a positive effect of monetary policy may be offset by a
negative one resulting from regulatory changes. The same holds for firms. If a decline in i is
accompanied by a radical shift in government policy towards private companies, e.g., a
deterioration in tax law making it less transparent and predictable, then companies may not
increase investment activities.
The Exchange Rate Channel. We have shown earlier that in the case of economies with bad
institutions an appreciation of domestic currency may shift investment schedule to the left
lowering the investment spending of the producers of tradables (see, Fig. 2b). In case of a
nontotallyinvestmentconstrainedeconomy an appreciation would counteract the positive
effect of a decrease in interest rate. How does that relate to the exchange rate channel? First,
we should analyze how institutions can affect the sensitivity of exchange rate changes to
interest rate movements. Second, we should focus on an extent to which exchange rate
matters for net export.
As for the first issue, we should notice that an appreciation is caused by an inflow of
foreign capital leading to a rise in deposits denominated in local currency. However, what
investors take into account is not only a higher interest rate, but also a perceived risk of such
an investment. That risk is primarily defined by the government actions towards financial
system. If the system is transparent and stable with high quality supervisory institutions, then
15 Here positive changes in regulatory framework can offset a small rise in i. However, if a rise in i is huge enough then a positive change in institutional settings won’t change the behavior of investments.
21
on the contrary, a decline in M but combined with a positive regulatory reform does not
necessarily lead to a decline in Y (subscript u stands for an unchanged variable and the
number of arrows describes the magnitude of change of a variable in question) and even can
be associated with a rise in Y. Systematically, we can write it down as follows:
Deteriorating institutions: M ↓ => i ↑ => I ↓↓ => Y ↓↓,
No change in institutions: M ↓ => i ↑ => I ↓ => Y ↓,
Positive regulatory reform: M ↓ => i ↑ => Iu (or I ↑) (or I ↓)15 => Yu (or Y ↑) (or Y ↓),
We claim here that institutional changes matter for firms’ and consumers’ behavior. If, for
instance, there is a rise in M leading to a decline in i and hence making consumers more
willing to buy houses, but, if, simultaneously, government is introducing a new law making
acquisition of private property by a public authority easier (e.g., when government wants to
acquire land for a new road), then a positive effect of monetary policy may be offset by a
negative one resulting from regulatory changes. The same holds for firms. If a decline in i is
accompanied by a radical shift in government policy towards private companies, e.g., a
deterioration in tax law making it less transparent and predictable, then companies may not
increase investment activities.
The Exchange Rate Channel. We have shown earlier that in the case of economies with bad
institutions an appreciation of domestic currency may shift investment schedule to the left
lowering the investment spending of the producers of tradables (see, Fig. 2b). In case of a
nontotallyinvestmentconstrainedeconomy an appreciation would counteract the positive
effect of a decrease in interest rate. How does that relate to the exchange rate channel? First,
we should analyze how institutions can affect the sensitivity of exchange rate changes to
interest rate movements. Second, we should focus on an extent to which exchange rate
matters for net export.
As for the first issue, we should notice that an appreciation is caused by an inflow of
foreign capital leading to a rise in deposits denominated in local currency. However, what
investors take into account is not only a higher interest rate, but also a perceived risk of such
an investment. That risk is primarily defined by the government actions towards financial
system. If the system is transparent and stable with high quality supervisory institutions, then
15 Here positive changes in regulatory framework can offset a small rise in i. However, if a rise in i is huge enough then a positive change in institutional settings won’t change the behavior of investments.
20
What happens when we have a positive and high interest rate, and there is a possibility that
expost TCs would not realize (e.g., I can be a lucky buyer and I can buy a parcel without any
law defect)? Now, an agent thinks as follows: I want to make a transaction, so I have to pay
some TCs, however, since interest rate is high maybe it would be better not to pay high ex
ante TCs but rather to invest money into profitable capital assets. Let’s have an intertemporal
interest rate of 30%. In order to make a deal our consumer should pay some TCs. He knows
that if he invests 100$ before transaction (exante TCs), then he will face expost TCs of 20$
with probability, p=0,2, and 0$ with p=0,8 (instead of 20$ with p=0,8 and 0$ with p=0,2 for
exante TCs=0). Thus investing 100$ exante diminishes his expected expost TCs from 16$
to 4$, so he saves 12$, however, investing 100$ on the market with 30% interest rate gives
him 30$. For sure it is better to put money into the bank account and not to pay high exante
TCs. Now, what happens if there is a decline in the interest rate to 10%? If he is a risklover,
he should invest and not to pay exante TCs. However, if the majority of consumers are risk
averse (or neutral), then they move from investing money into bank accounts (or some capital
assets) to pay exante TCs. Let’s assume that people generally do not like risk, so a decline in
the interest rate makes them use the institutions enabling transactions. That matters especially
for the savingconstrained economies. If interest rates are high, then people may not be
interested in the shape of the tradeoff between exante and expost TCs, because they are
betteroff while putting money into the bank account even if they have to pay expost TCs. If
it is so, then institutional fabric of the society may deteriorate. Therefore, financial
globalization may have a positive effect on the savingconstrained economies, since it often
makes using transaction services necessary and hence it stimulate people to think why a trade
off is such or such. What follows is that they will try to induce, or at least think of, regulatory
reforms. Now, after discussing the role of institutions and their potential effects on the extent
to which monetary policy affects economy, we come back to basic transmission mechanisms
described in section 2 and we show how institutional changes can be integrated into that
framework.
The interest credit channel. Here we want to check to what extent the transmission
mechanisms presented earlier are sensitive to changes in institutional settings. In fact, in our
discussion on financial globalization we referred to the interest rate channel. So, the effect of
a decline in M can be more negative to changes in Y in case of deteriorating institutions. And,
Putting institutions into transmission mechanisms
WORKING PAPER No. 96 25
4
21
on the contrary, a decline in M but combined with a positive regulatory reform does not
necessarily lead to a decline in Y (subscript u stands for an unchanged variable and the
number of arrows describes the magnitude of change of a variable in question) and even can
be associated with a rise in Y. Systematically, we can write it down as follows:
Deteriorating institutions: M ↓ => i ↑ => I ↓↓ => Y ↓↓,
No change in institutions: M ↓ => i ↑ => I ↓ => Y ↓,
Positive regulatory reform: M ↓ => i ↑ => Iu (or I ↑) (or I ↓)15 => Yu (or Y ↑) (or Y ↓),
We claim here that institutional changes matter for firms’ and consumers’ behavior. If, for
instance, there is a rise in M leading to a decline in i and hence making consumers more
willing to buy houses, but, if, simultaneously, government is introducing a new law making
acquisition of private property by a public authority easier (e.g., when government wants to
acquire land for a new road), then a positive effect of monetary policy may be offset by a
negative one resulting from regulatory changes. The same holds for firms. If a decline in i is
accompanied by a radical shift in government policy towards private companies, e.g., a
deterioration in tax law making it less transparent and predictable, then companies may not
increase investment activities.
The Exchange Rate Channel. We have shown earlier that in the case of economies with bad
institutions an appreciation of domestic currency may shift investment schedule to the left
lowering the investment spending of the producers of tradables (see, Fig. 2b). In case of a
nontotallyinvestmentconstrainedeconomy an appreciation would counteract the positive
effect of a decrease in interest rate. How does that relate to the exchange rate channel? First,
we should analyze how institutions can affect the sensitivity of exchange rate changes to
interest rate movements. Second, we should focus on an extent to which exchange rate
matters for net export.
As for the first issue, we should notice that an appreciation is caused by an inflow of
foreign capital leading to a rise in deposits denominated in local currency. However, what
investors take into account is not only a higher interest rate, but also a perceived risk of such
an investment. That risk is primarily defined by the government actions towards financial
system. If the system is transparent and stable with high quality supervisory institutions, then
15 Here positive changes in regulatory framework can offset a small rise in i. However, if a rise in i is huge enough then a positive change in institutional settings won’t change the behavior of investments.
22
investors generally are more willing to invest. In our framework, for a given exante TCs
associated with transaction, they are confronted with a lower expost TCs. We can state also
that a “real” interest rate a foreign investor is facing is a “nominal” exchange rate minus
marginal TCs she is to pay. As the second effect is concerned, what matters is the institutional
framework for international trade. Let’s assume that a foreign supplier of a given good is not
only interested in its relative price but also he takes into account a risk associated with
trading. Therefore, a low quality juridical system which makes enforcing the contracts a time
consuming and costly activity may make foreign contractors less wiling to export what can
result in higher prices they have to offer in order to offset that risk. The situation can be
reversed with a positive institutional change abroad and a negative one or a status quo
domestically. Schematically, we can write these interdependencies as follows:
(1) M ↓ => i ↑ => [in case of well functioning financial markets] E ↑ => [no change in
domestic institutions defining risk associated with trading] NX ↓ => Y ↓
(2) M ↓ => i ↑ => [in case of well functioning financial markets] E ↑ => [a change towards
domestic institutions nondiminishing risk associated with trading] NXu => Yu
(3) M ↓ => i ↑ => [in case of high TCs in financial markets] Eu => [no change in domestic
institutions defining risk associated with trading] NXu => Yu
(4) M ↓ => i ↑ => [in case of high TCs in financial markets] Eu => [a change towards
domestic institutions diminishing risk associated with trading] NX ↓=> Yu ↓
Here (1) sequence of events is textbook like. The remaining three are worth commenting on.
In case of (2) the government by worsening the institutions (i.e., for the same exante TCs a
raise in expost TCs) may offset the effect of an appreciation. It means that domestic
institutional change can influence the functioning of an exchange rate channel, namely foreign
suppliers are no more willing to sell goods for a country with a bad quality institutional
settings. As (3) is concerned, there is no change in exchange rate due to high TCs in financial
markets. And in (4) even with no change in exchange rate we may have a change in net
export. A quite surprising conclusion, in (4), could thus be that a positive regulatory change
can increase NX by making foreign investors more willing to sell goods for such a country.
Putting institutions into transmission mechanisms
N a t i o n a l B a n k o f P o l a n d26
4
23
Tobin’s q theory. Here monetary policy influences the real side of economy by its effects on
the valuation of equities, e.g., falling Pe makes q diminishing and hence firms lower
investment spending. Here we should investigate the three steps in that transmission
mechanism where institutions can (potentially) matter. First, whether institutions can affect
the magnitude by which Pe reacts to changes in M. Second, the role of institutions in defining
the interplay between Pe and q. And thirdly, between q and I.
As for the first step, the impact of changes in M on Pe depends on the consumers’
reallocation of spending. In monetarist view there is an assumption that consumers are to
reduce purchases of equities since they have less money to allocate (an effect of M ↓). Also, a
fall in M leads to an increase in i which makes investments in equities less profitable
relatively to bank deposits. An interesting question could be whether by changing institutions
consumers can keep their spending on equities unchanged in the presence of a decline in M. In
other words, whether they can reduce their nonequity spending. It seems that in a short run
for relatively small changes in M government by changing institutions can keep public
spending on equities unchanged, e.g., a decline in tax on profits from capital investment can
occurred or by an appropriate change in law the government can ease stock trading and makes
new entities enter the stock market. However, it is hardly imaginable in practice that public
authorities would counteract small changes in M with institutional changes in law defining the
functioning of a market for equities. Therefore, institutions do not have an important role in
defining the elasticity of changes in Pe to moves of M at least in the short run, however, in the
long run, by making the business environment more friendly to business firms, the
government can have a positive impact on their profits and hence prices of equities.
Now, how changes in institutional structure of market can affect the impact of
changings of Pe on q? As q is defined as market values of firms divided by replacement cost
of capital, we should ask how changes in institutions can influence MVF and RCC. Since
MVF is just a function of Pe, there should not be a direct role for institutions in defining
market values of firms. However, as we have just written above, in the long run the
government can positively stimulate the growth of MVF. The value of RCC is here an
“exogenous” variable and is defined internally by a given firm willingness (and need) to
acquire new capital.
As for the third step, namely the interplay between q and I, there is an important role
for institutions to play. Diminishing q signifies less money companies have to make
investments. However, in the basic Tobin q model there is an assumption that firms in their
investment activities are constrained by lack of money, however, we have shown earlier in
22
investors generally are more willing to invest. In our framework, for a given exante TCs
associated with transaction, they are confronted with a lower expost TCs. We can state also
that a “real” interest rate a foreign investor is facing is a “nominal” exchange rate minus
marginal TCs she is to pay. As the second effect is concerned, what matters is the institutional
framework for international trade. Let’s assume that a foreign supplier of a given good is not
only interested in its relative price but also he takes into account a risk associated with
trading. Therefore, a low quality juridical system which makes enforcing the contracts a time
consuming and costly activity may make foreign contractors less wiling to export what can
result in higher prices they have to offer in order to offset that risk. The situation can be
reversed with a positive institutional change abroad and a negative one or a status quo
domestically. Schematically, we can write these interdependencies as follows:
(1) M ↓ => i ↑ => [in case of well functioning financial markets] E ↑ => [no change in
domestic institutions defining risk associated with trading] NX ↓ => Y ↓
(2) M ↓ => i ↑ => [in case of well functioning financial markets] E ↑ => [a change towards
domestic institutions nondiminishing risk associated with trading] NXu => Yu
(3) M ↓ => i ↑ => [in case of high TCs in financial markets] Eu => [no change in domestic
institutions defining risk associated with trading] NXu => Yu
(4) M ↓ => i ↑ => [in case of high TCs in financial markets] Eu => [a change towards
domestic institutions diminishing risk associated with trading] NX ↓=> Yu ↓
Here (1) sequence of events is textbook like. The remaining three are worth commenting on.
In case of (2) the government by worsening the institutions (i.e., for the same exante TCs a
raise in expost TCs) may offset the effect of an appreciation. It means that domestic
institutional change can influence the functioning of an exchange rate channel, namely foreign
suppliers are no more willing to sell goods for a country with a bad quality institutional
settings. As (3) is concerned, there is no change in exchange rate due to high TCs in financial
markets. And in (4) even with no change in exchange rate we may have a change in net
export. A quite surprising conclusion, in (4), could thus be that a positive regulatory change
can increase NX by making foreign investors more willing to sell goods for such a country.
Putting institutions into transmission mechanisms
WORKING PAPER No. 96 27
4
23
Tobin’s q theory. Here monetary policy influences the real side of economy by its effects on
the valuation of equities, e.g., falling Pe makes q diminishing and hence firms lower
investment spending. Here we should investigate the three steps in that transmission
mechanism where institutions can (potentially) matter. First, whether institutions can affect
the magnitude by which Pe reacts to changes in M. Second, the role of institutions in defining
the interplay between Pe and q. And thirdly, between q and I.
As for the first step, the impact of changes in M on Pe depends on the consumers’
reallocation of spending. In monetarist view there is an assumption that consumers are to
reduce purchases of equities since they have less money to allocate (an effect of M ↓). Also, a
fall in M leads to an increase in i which makes investments in equities less profitable
relatively to bank deposits. An interesting question could be whether by changing institutions
consumers can keep their spending on equities unchanged in the presence of a decline in M. In
other words, whether they can reduce their nonequity spending. It seems that in a short run
for relatively small changes in M government by changing institutions can keep public
spending on equities unchanged, e.g., a decline in tax on profits from capital investment can
occurred or by an appropriate change in law the government can ease stock trading and makes
new entities enter the stock market. However, it is hardly imaginable in practice that public
authorities would counteract small changes in M with institutional changes in law defining the
functioning of a market for equities. Therefore, institutions do not have an important role in
defining the elasticity of changes in Pe to moves of M at least in the short run, however, in the
long run, by making the business environment more friendly to business firms, the
government can have a positive impact on their profits and hence prices of equities.
Now, how changes in institutional structure of market can affect the impact of
changings of Pe on q? As q is defined as market values of firms divided by replacement cost
of capital, we should ask how changes in institutions can influence MVF and RCC. Since
MVF is just a function of Pe, there should not be a direct role for institutions in defining
market values of firms. However, as we have just written above, in the long run the
government can positively stimulate the growth of MVF. The value of RCC is here an
“exogenous” variable and is defined internally by a given firm willingness (and need) to
acquire new capital.
As for the third step, namely the interplay between q and I, there is an important role
for institutions to play. Diminishing q signifies less money companies have to make
investments. However, in the basic Tobin q model there is an assumption that firms in their
investment activities are constrained by lack of money, however, we have shown earlier in
24
our debate on financial globalization that in case of investment constrained economies firms
are somehow constrained by “bad” institution and not by the lack of financial resources. We
can assume that in the situation of growing elasticity of investment schedule of a given
economy to changes in i we may have also a growing elasticity of I with respect to q. Thus
institutions matter for Tobin q monetary transmission channel. Schematically, we can present
that as follows:
M ↓ => Pe ↓ => q ↓ => [no change in institutions] I ↓ => Y↓.
M ↓ => Pe ↓ => q ↓ => [positive regulatory reform] Iu (or I ↑) => Yu (or Y ↑).
Credit channel. In credit channel of monetary transmission institutions are per se important
since government interventions have a huge effect on credit supply. However, they are also
important in balancesheet channel where decreasing Pe leads to growing problems of adverse
selection and moral hazard and hence to a decrease in lending. Here the role of institutions
can be to reduce the problems of adverse selection and moral hazard, i.e., institutions should
be used here to diminish informational gap between banks and firms (or private customers)
(problem of asymmetric information). If banks can cheaply get information about financial
condition of firms (consumers), then they should relatively well cope with adverse selection
and moral hazard issues. There are plenty of institutional innovations aiming at reducing
asymmetric information between banks and prospective borrowers, e.g., easily accessible
registries of debtors, various quality standards the firms can acquire in order to signal external
partners about their transparency and quality of management, ethical codes of conduct the
firms can introduce, and last but not least an efficient legal system of enforcing contracts, etc.
With such institutions, diminishing Pe does not have to lead to a decrease in banks’ lending
activities, i.e.:
M ↓ => Pe ↓ => adverse selection ↑ & moral hazard ↑ => [better regulations] lendingu
(or even ↑) => Iu (or even I ↑) => Yu (or even Y ↑).
Also, institutions matter for the way the socalled liquidityeffects channel works. Here it is
assumed that in the presence of a growing likelihood of financial distress on the side of
consumer he would diminish spending on illiquid assets, e.g., houses. Having in mind that
particular markets are naturally characterized by low liquidity, there is however a place for
institutional innovations aiming at making such markets more liquid, e.g., by easing the
Putting institutions into transmission mechanisms
N a t i o n a l B a n k o f P o l a n d28
4
25
access to information about possible trading deals, by making land registry and notarial
system more efficient, etc. Schematically, it can be noted as follows:
M ↓ => Pe ↓ => financial assets ↓ => likelihood of financial distress ↑ => [introduction of
institutions making housing market more liquid] consumer durable
and housing expendituresu (or even ↑) => Yu. (or even ↑)
The fact that institutions matter for monetary transmission can have an important effect for
economic policy, since by changing institutions one can largely influence the effects of
monetary policy. In that sense different institutional settings can explain different results of
the same monetary actions in different time periods characterized by diverse regulatory
regimes. Some empirical analysis support conclusions of this sort, e.g., Calza et al. (2007)
show that the correlation of consumption growth with changes in house prices is higher in
countries with more developed mortgage markets; Iacoviello et al. (2008) present evidence
that balance sheet channel affects households more in countries with less developed mortgage
finance systems16. However, the extent by which regulatory policy can be used to offset the
effects of monetary actions is limited in the short run since it is difficult to change institutions
overnight. Here lies an important difference with fiscal policy which can be changed more
quickly. On the other hand, in the medium run, many regulations influencing the ways
monetary transmission mechanisms work can be change, including law regulating credit
markets where an important role is played by the rules defined by supervisory authorities.
That is why while crafting economic policy a due attention should paid to regulatory changes.
The post 2008 global crisis proved that regulations matter and that monetary authorities
cannot neglect the role institutions play in financial markets.
Although we have shown the most important channels of monetary transmission, we are
conscious that there are many more to investigate. However, the aim of the paper was just to
introduce the issue of the interplay between monetary and regulatory policies. It turned out
that the extent to which monetary policy affects the real side of the economy is largely
influenced by its institutional fabric. However, in order to be significantly important
16 A survey of that literature is presented in Boivin et al. (2010).
25
access to information about possible trading deals, by making land registry and notarial
system more efficient, etc. Schematically, it can be noted as follows:
M ↓ => Pe ↓ => financial assets ↓ => likelihood of financial distress ↑ => [introduction of
institutions making housing market more liquid] consumer durable
and housing expendituresu (or even ↑) => Yu. (or even ↑)
The fact that institutions matter for monetary transmission can have an important effect for
economic policy, since by changing institutions one can largely influence the effects of
monetary policy. In that sense different institutional settings can explain different results of
the same monetary actions in different time periods characterized by diverse regulatory
regimes. Some empirical analysis support conclusions of this sort, e.g., Calza et al. (2007)
show that the correlation of consumption growth with changes in house prices is higher in
countries with more developed mortgage markets; Iacoviello et al. (2008) present evidence
that balance sheet channel affects households more in countries with less developed mortgage
finance systems16. However, the extent by which regulatory policy can be used to offset the
effects of monetary actions is limited in the short run since it is difficult to change institutions
overnight. Here lies an important difference with fiscal policy which can be changed more
quickly. On the other hand, in the medium run, many regulations influencing the ways
monetary transmission mechanisms work can be change, including law regulating credit
markets where an important role is played by the rules defined by supervisory authorities.
That is why while crafting economic policy a due attention should paid to regulatory changes.
The post 2008 global crisis proved that regulations matter and that monetary authorities
cannot neglect the role institutions play in financial markets.
Although we have shown the most important channels of monetary transmission, we are
conscious that there are many more to investigate. However, the aim of the paper was just to
introduce the issue of the interplay between monetary and regulatory policies. It turned out
that the extent to which monetary policy affects the real side of the economy is largely
influenced by its institutional fabric. However, in order to be significantly important
16 A survey of that literature is presented in Boivin et al. (2010).
Conclusions
WORKING PAPER No. 96 29
5
25
access to information about possible trading deals, by making land registry and notarial
system more efficient, etc. Schematically, it can be noted as follows:
M ↓ => Pe ↓ => financial assets ↓ => likelihood of financial distress ↑ => [introduction of
institutions making housing market more liquid] consumer durable
and housing expendituresu (or even ↑) => Yu. (or even ↑)
The fact that institutions matter for monetary transmission can have an important effect for
economic policy, since by changing institutions one can largely influence the effects of
monetary policy. In that sense different institutional settings can explain different results of
the same monetary actions in different time periods characterized by diverse regulatory
regimes. Some empirical analysis support conclusions of this sort, e.g., Calza et al. (2007)
show that the correlation of consumption growth with changes in house prices is higher in
countries with more developed mortgage markets; Iacoviello et al. (2008) present evidence
that balance sheet channel affects households more in countries with less developed mortgage
finance systems16. However, the extent by which regulatory policy can be used to offset the
effects of monetary actions is limited in the short run since it is difficult to change institutions
overnight. Here lies an important difference with fiscal policy which can be changed more
quickly. On the other hand, in the medium run, many regulations influencing the ways
monetary transmission mechanisms work can be change, including law regulating credit
markets where an important role is played by the rules defined by supervisory authorities.
That is why while crafting economic policy a due attention should paid to regulatory changes.
The post 2008 global crisis proved that regulations matter and that monetary authorities
cannot neglect the role institutions play in financial markets.
Although we have shown the most important channels of monetary transmission, we are
conscious that there are many more to investigate. However, the aim of the paper was just to
introduce the issue of the interplay between monetary and regulatory policies. It turned out
that the extent to which monetary policy affects the real side of the economy is largely
influenced by its institutional fabric. However, in order to be significantly important
16 A survey of that literature is presented in Boivin et al. (2010).
25
access to information about possible trading deals, by making land registry and notarial
system more efficient, etc. Schematically, it can be noted as follows:
M ↓ => Pe ↓ => financial assets ↓ => likelihood of financial distress ↑ => [introduction of
institutions making housing market more liquid] consumer durable
and housing expendituresu (or even ↑) => Yu. (or even ↑)
The fact that institutions matter for monetary transmission can have an important effect for
economic policy, since by changing institutions one can largely influence the effects of
monetary policy. In that sense different institutional settings can explain different results of
the same monetary actions in different time periods characterized by diverse regulatory
regimes. Some empirical analysis support conclusions of this sort, e.g., Calza et al. (2007)
show that the correlation of consumption growth with changes in house prices is higher in
countries with more developed mortgage markets; Iacoviello et al. (2008) present evidence
that balance sheet channel affects households more in countries with less developed mortgage
finance systems16. However, the extent by which regulatory policy can be used to offset the
effects of monetary actions is limited in the short run since it is difficult to change institutions
overnight. Here lies an important difference with fiscal policy which can be changed more
quickly. On the other hand, in the medium run, many regulations influencing the ways
monetary transmission mechanisms work can be change, including law regulating credit
markets where an important role is played by the rules defined by supervisory authorities.
That is why while crafting economic policy a due attention should paid to regulatory changes.
The post 2008 global crisis proved that regulations matter and that monetary authorities
cannot neglect the role institutions play in financial markets.
Although we have shown the most important channels of monetary transmission, we are
conscious that there are many more to investigate. However, the aim of the paper was just to
introduce the issue of the interplay between monetary and regulatory policies. It turned out
that the extent to which monetary policy affects the real side of the economy is largely
influenced by its institutional fabric. However, in order to be significantly important
16 A survey of that literature is presented in Boivin et al. (2010).
25
access to information about possible trading deals, by making land registry and notarial
system more efficient, etc. Schematically, it can be noted as follows:
M ↓ => Pe ↓ => financial assets ↓ => likelihood of financial distress ↑ => [introduction of
institutions making housing market more liquid] consumer durable
and housing expendituresu (or even ↑) => Yu. (or even ↑)
The fact that institutions matter for monetary transmission can have an important effect for
economic policy, since by changing institutions one can largely influence the effects of
monetary policy. In that sense different institutional settings can explain different results of
the same monetary actions in different time periods characterized by diverse regulatory
regimes. Some empirical analysis support conclusions of this sort, e.g., Calza et al. (2007)
show that the correlation of consumption growth with changes in house prices is higher in
countries with more developed mortgage markets; Iacoviello et al. (2008) present evidence
that balance sheet channel affects households more in countries with less developed mortgage
finance systems16. However, the extent by which regulatory policy can be used to offset the
effects of monetary actions is limited in the short run since it is difficult to change institutions
overnight. Here lies an important difference with fiscal policy which can be changed more
quickly. On the other hand, in the medium run, many regulations influencing the ways
monetary transmission mechanisms work can be change, including law regulating credit
markets where an important role is played by the rules defined by supervisory authorities.
That is why while crafting economic policy a due attention should paid to regulatory changes.
The post 2008 global crisis proved that regulations matter and that monetary authorities
cannot neglect the role institutions play in financial markets.
Although we have shown the most important channels of monetary transmission, we are
conscious that there are many more to investigate. However, the aim of the paper was just to
introduce the issue of the interplay between monetary and regulatory policies. It turned out
that the extent to which monetary policy affects the real side of the economy is largely
influenced by its institutional fabric. However, in order to be significantly important
16 A survey of that literature is presented in Boivin et al. (2010).
26
institutions must not change only not for its own sake but in order to reduce the sum of
various transaction costs resulting from an exchange. We have shown also that what
particularly matters is the impact of institutions on the elasticity of investments to changes in
interest rate or broadly speaking access to capital. That is why we made a reference to the
financial globalization debate where the notions of saving and investment constrained
economies are used. In the case of the former the monetary mechanism is of a textbook
character – a lower interest rate positively stimulates investments. However, in the case of the
latter “bad” institutions make a transmission mechanism to stop working – even with low
interest rate companies do not want to invest. We think that further research is needed in order
to investigate the role of institutions in the way transmission mechanisms are working.
Acemoglu D., Johnson S. (2005), ‘Unbundling Institutions’, Journal of Political Economy, vol. 113(5): 949995.
Acemoglu D., Johnson S., Robinson J. (2004), ‘Institutions as the Fundamental Cause of Longrun Growth’, NBER Working Paper 10481.
Boivin J., Kiley M. T., Mishkin F. S. (2010), ‘How Has the Monetary Transmission Mechanism Evolved Over Time?’,
Bernanke B. S., Gertler M. (1995), ‘Inside the Black Box: The Credit Channel of Monetary Policy Transmission’, Journal of Economic Perspectives, vol. 9(4): 2748.
Calza A., Monacelli T., Stracca L. (2007), ‘Mortgage Markets, Collateral Constraints, and Monetary Policy: Do Institutional Factors Matter?’, CEPR Discussion Papers 6231.
Dixit A K. (2004), Lawlessness and Economics : Alternative Modes of Economic Governance, CUP, Cambridge.
Dixit A. K. (1996), The Making of Economic Policy, The MIT Press, Cambridge MA.
Dornbusch R. (1998), ‘Capital Controls: An Idea Whose Time is Past’, in: S. Fischer et al. (eds.), Should the IMF Pursue CapitalAccount Convertibility? Essays in International Finance, No. 207, Princeton University.
Fischer S. (1997), ‘Capital Account Liberalization and the Role of the IMF’, speech at the IMF Annual Meetings, September 19, 1997.
Furubotn E. G., Richter R. (2000), Institutions and Economic Theory, The University of Michigan Press, Ann Arbor.
Green J., Sheshinski E. (1975), ‘Competitive Inefficiencies in the Presence of Constrained Transactions’, Journal of Economic Theory, vol. 10(3): 343357.
Hardt Ł. (2009), ‘The History of Transaction Cost Economics and its Recent Developments’, Erasmus Journal for Economics and Philosophy, vol. 2(1): 2951.
References
N a t i o n a l B a n k o f P o l a n d30
27
Hardt Ł. (2010), Ekonomia kosztów transakcyjnych – geneza i kierunki rozwoju, WUW, Warszawa.
Henry P. B. (2007), ‘Capital Account Liberalization: Theory, Evidence, and Speculation’, Journal of Economic Literature, vol. 65: 887935.
Iacoviello M., Minetti R. (2008), ’The Credit Channel of Monetary Policy: Evidence from the Housing Market’, Journal of Macroeconomics, vol. 30(1): 6996.
Kose M. A., Prasad E., Rogoff K., Wei S. J. (2006), ‘Financial Globalization: A Reappraisal’, Harvard University.
Lucas R. (1988), ‘On the Mechanics of Economic Development’, Journal of Monetary Economics, vol. 22: 342.
Martens B. (2004), The Cognitive Mechanisms of Economic Development and Institutional Change, Routledge, London.
Meltzer A. H. (1995), ‘Monetary, Credit and (Other) Transmission Processes: A Monetarist Perspective’, Journal of Economic Perspectives, vol. 9(4): pages 4972.
Mishkin F. S. (1978), ‘The Household BalanceSheet and the Great Depression’, Journal of Economic History, vol. 38: 918937.
Mishkin F. S. (1995), ‘Symposium on the Monetary Transmission Mechanism’, Journal of Economic Perspective, vol. 9(4): 310.
Mishkin F. S. (2006), The Next Great Globalization: How Disadvantaged Nations can Harness their Financial Systems to Get Rich, Princeton University Press, Princeton NJ.
Modigliani F. (1991), ‘Monetary Policy and Consumption’, in: Consumer Spending and Monetary Policy, Federal Reserve Bank of Boston, Boston, 984.
Niehans J. (1971), ‘Money and Barter in General Equilibrium with Transaction Costs’, American Economic Review, vol. 61(5): 773783.
North D. C. (1990), Institutions, Institutional Change and Economic Performance, Cambridge University Press, Cambridge MA.
North D. C. (1993), ‘Institutions, Transaction Costs, and Productivity in the Long Run’, Washington University in St. Louis.
North D. C. (2005), Understanding the Process of Economic Change, Princeton University Press, Princeton NJ.
Obstfeld M., Rogoff K. (1995), ‘The Mirage of Fixed Exchange Rates’, Journal of Economic Perspectives, vol. 9(4): 7396.
Rodrik D. (2008a), ‘SecondBest Institutions’, NBER Working Papers 14050.
Rodrik D. (2008b), One Economics, Many Recipes: Globalization, Institutions, and Economic Growth, Princeton University Press, Princeton NJ.
Rodrik D., Subramanian A., Trebbi F. (2004), ‘Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development’, Journal of Economic Growth, vol. 9(2): 131165.
Rodrik D., Subramanian A. (2009), ‘Why Did Financial Globalization Disappoint?’, IMF Staff Papers, vol. 56(1): 112138.
Romer P. (1986), ‘Increasing Returns and Longrun Growth’, Journal of Political Economy, vol. 94: 10021037.
26
institutions must not change only not for its own sake but in order to reduce the sum of
various transaction costs resulting from an exchange. We have shown also that what
particularly matters is the impact of institutions on the elasticity of investments to changes in
interest rate or broadly speaking access to capital. That is why we made a reference to the
financial globalization debate where the notions of saving and investment constrained
economies are used. In the case of the former the monetary mechanism is of a textbook
character – a lower interest rate positively stimulates investments. However, in the case of the
latter “bad” institutions make a transmission mechanism to stop working – even with low
interest rate companies do not want to invest. We think that further research is needed in order
to investigate the role of institutions in the way transmission mechanisms are working.
Acemoglu D., Johnson S. (2005), ‘Unbundling Institutions’, Journal of Political Economy, vol. 113(5): 949995.
Acemoglu D., Johnson S., Robinson J. (2004), ‘Institutions as the Fundamental Cause of Longrun Growth’, NBER Working Paper 10481.
Boivin J., Kiley M. T., Mishkin F. S. (2010), ‘How Has the Monetary Transmission Mechanism Evolved Over Time?’,
Bernanke B. S., Gertler M. (1995), ‘Inside the Black Box: The Credit Channel of Monetary Policy Transmission’, Journal of Economic Perspectives, vol. 9(4): 2748.
Calza A., Monacelli T., Stracca L. (2007), ‘Mortgage Markets, Collateral Constraints, and Monetary Policy: Do Institutional Factors Matter?’, CEPR Discussion Papers 6231.
Dixit A K. (2004), Lawlessness and Economics : Alternative Modes of Economic Governance, CUP, Cambridge.
Dixit A. K. (1996), The Making of Economic Policy, The MIT Press, Cambridge MA.
Dornbusch R. (1998), ‘Capital Controls: An Idea Whose Time is Past’, in: S. Fischer et al. (eds.), Should the IMF Pursue CapitalAccount Convertibility? Essays in International Finance, No. 207, Princeton University.
Fischer S. (1997), ‘Capital Account Liberalization and the Role of the IMF’, speech at the IMF Annual Meetings, September 19, 1997.
Furubotn E. G., Richter R. (2000), Institutions and Economic Theory, The University of Michigan Press, Ann Arbor.
Green J., Sheshinski E. (1975), ‘Competitive Inefficiencies in the Presence of Constrained Transactions’, Journal of Economic Theory, vol. 10(3): 343357.
Hardt Ł. (2009), ‘The History of Transaction Cost Economics and its Recent Developments’, Erasmus Journal for Economics and Philosophy, vol. 2(1): 2951.
References
WORKING PAPER No. 96 31
27
Hardt Ł. (2010), Ekonomia kosztów transakcyjnych – geneza i kierunki rozwoju, WUW, Warszawa.
Henry P. B. (2007), ‘Capital Account Liberalization: Theory, Evidence, and Speculation’, Journal of Economic Literature, vol. 65: 887935.
Iacoviello M., Minetti R. (2008), ’The Credit Channel of Monetary Policy: Evidence from the Housing Market’, Journal of Macroeconomics, vol. 30(1): 6996.
Kose M. A., Prasad E., Rogoff K., Wei S. J. (2006), ‘Financial Globalization: A Reappraisal’, Harvard University.
Lucas R. (1988), ‘On the Mechanics of Economic Development’, Journal of Monetary Economics, vol. 22: 342.
Martens B. (2004), The Cognitive Mechanisms of Economic Development and Institutional Change, Routledge, London.
Meltzer A. H. (1995), ‘Monetary, Credit and (Other) Transmission Processes: A Monetarist Perspective’, Journal of Economic Perspectives, vol. 9(4): pages 4972.
Mishkin F. S. (1978), ‘The Household BalanceSheet and the Great Depression’, Journal of Economic History, vol. 38: 918937.
Mishkin F. S. (1995), ‘Symposium on the Monetary Transmission Mechanism’, Journal of Economic Perspective, vol. 9(4): 310.
Mishkin F. S. (2006), The Next Great Globalization: How Disadvantaged Nations can Harness their Financial Systems to Get Rich, Princeton University Press, Princeton NJ.
Modigliani F. (1991), ‘Monetary Policy and Consumption’, in: Consumer Spending and Monetary Policy, Federal Reserve Bank of Boston, Boston, 984.
Niehans J. (1971), ‘Money and Barter in General Equilibrium with Transaction Costs’, American Economic Review, vol. 61(5): 773783.
North D. C. (1990), Institutions, Institutional Change and Economic Performance, Cambridge University Press, Cambridge MA.
North D. C. (1993), ‘Institutions, Transaction Costs, and Productivity in the Long Run’, Washington University in St. Louis.
North D. C. (2005), Understanding the Process of Economic Change, Princeton University Press, Princeton NJ.
Obstfeld M., Rogoff K. (1995), ‘The Mirage of Fixed Exchange Rates’, Journal of Economic Perspectives, vol. 9(4): 7396.
Rodrik D. (2008a), ‘SecondBest Institutions’, NBER Working Papers 14050.
Rodrik D. (2008b), One Economics, Many Recipes: Globalization, Institutions, and Economic Growth, Princeton University Press, Princeton NJ.
Rodrik D., Subramanian A., Trebbi F. (2004), ‘Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development’, Journal of Economic Growth, vol. 9(2): 131165.
Rodrik D., Subramanian A. (2009), ‘Why Did Financial Globalization Disappoint?’, IMF Staff Papers, vol. 56(1): 112138.
Romer P. (1986), ‘Increasing Returns and Longrun Growth’, Journal of Political Economy, vol. 94: 10021037.
28
Svensson J. (2005), ‘Eight Questions about Corruption’, Journal of Economic Perspectives, vol. 19(3): 1942.
Taylor J. B. (1995), ‘The Monetary Transmission Mechanism: An Empirical Framework’, Journal of Economic Perspectives, vol. 9(4): 1126.
Tobin J. (1970), ‘Money and Income: Post Hoc Ergo Propter Hoc?’, The Quarterly Journal of Economics, vol. 84(2): 301317.
Walsh C. E. (2010), Monetary Theory and Policy, The MIT Press, Cambridge MA.
Williamson O. E. (1991), ‘Comparative Economic Organization: The Analysis of Discrete Structural Alternatives’, Administrative Science Quarterly, vol. 36(2): 269296.